Why You Should Invest in Mutual Funds Through Sip

Today, one of the most popular and well understood terms in mutual fund investing is Systematic investment plan (SIP). For most long term investors looking at a horizon of over 10-15 years, equity funds have emerged as the favourite instrument for generating wealth in the long run. Let us understand why the SIPs generate wealth in the long run?

That is because equities in the long term are immune to the tops and bottoms of the market. What matters is how you are able to take a disciplined approach to investing and invest in a consistent and regular manner. But, what exactly drives SIPs to create wealth?

SIP appears to be a very easy method of creating wealth in the long run. However, there are five factors that will determine the success of your SIP.

Focus on quality and high return equities

• Start early even if you start small.

• Treat SIP as a regular commitment

• Don’t exert about buying the lows and selling the highs

• Prefer the growth option over dividend option

Now, does that look like a lot of esoteric stuff? You may be wondering how SIPs can create wealth by starting small or how you don’t have to both about market lows and tops. Let us simplify each of the above points.

Interestingly, you can. Start early even if you start small and that is the key. Even small investments can grow into big numbers if you stay invested for a longer period. This is called the principal of compounding. What it says is that, the earlier you start, the more your principal earns returns and the more your returns generate further returns. That is power of compound, but let us take an example.

The above is a live example of 4 investors. You can see how Investor-A has generated the maximum wealth at the age of 55, even though his monthly SIP is the smallest. The only reason is that Investor-A starts at the age of 25 and so gets a full 30 years for his investment in the SIP to grow. He ends up with Rs.2.78 crore at the age of 55.

If you look at the above table of the four investors, Investor-A would have not have ended up with so much wealth if he had stopped the SIP in between. SIP is all about discipline. If you commit that you will invest Rs.5000 each month in an equity fund, then the discipline is important. You must sustain over a period of time. The SIP is a commitment so the key is to first decide on the SIP and then build your family budget around that. Don’t skip a SIP once it is started.

Doubt 3: You ask to invest in equity fund SIPs, but are they not risky?

You will be surprised that the chances of earning negative return on equity if you hold for more than 6 months is almost zero. In the long run, the biggest risk is not taking enough risk. If you want to retire rich, then putting the money in liquid funds is not the answer. Ensure that your SIP is invested in high return equities. That is the only way to creating wealth in the long term. Liquid funds give you 3% post tax so even if you continue with your liquid fund SIP for 25 years you cannot generate anything worthwhile. You need power of equity funds over the long term. In the long term, the risk is largely neutralized.

Doubt 4: I am not clear about not having to time the market?

In SIPs, it is time and not timing the matters. In the longer run, you must stay invested and not bother about the lows and highs. It has been observed that if you try to time the market and just miss out 2-3 extremes in the market, you earn less than a SIP. The moral of the story is that timing does not add value. You are better off with a discipline SIP approach. Also, don’t try to reduce the SIP if markets go up or increase the SIP if markets go down. You are breaking your own discipline based on your judgement.

Doubt 5: Should I select growth option or dividend option for SIPs?

Simple rule. Remember, SIPs are about compounding you wealth over time. Here, growth options are auto compounders. In a dividend plan, you earn the dividend and spend it elsewhere. So the reinvestment benefit is lost and you end up with much lower returns. Unless you reinvest the dividend at similar yields (which is generally impractical) you are going to destroy long term wealth. There is also the tax aspect. Dividends are less tax efficient compared to capital gains. Rather opt for growth plans.