SYSTEMATIC INVESTMENT PLAN (SIP)

SYSTEMATIC INVESTMENT PLAN (SIP)

What is SIP?

A systematic investment plan (SIP) commits the investor to invest a specified amount every month (or every quarter) in the units of a fund’s equity scheme. The number of units bought each month for the investor under the plan will depend on the ruling price: fewer units are bought when the price is high, and more units are bought when price is low.
This is a built-in advantage of SIPs. It averages out investor’s buying price over the entire period of holding. The SIP resolves a dilemma often facing investors due to ups and downs in the market price. The investor finds it difficult to decide when to invest in the equity scheme.

The monthly or quarterly amount to be invested can be as small as Rs. 500 or Rs. 1000. Mutual funds specify the schemes for which SIP is allowed by them. Some funds charge a lower entry load under SIP than for one-time investment, but others don’t make any such distinction. An exit load under SIP is charged if the investor leaves the scheme before a specific period of time.

When is SIP advantageous?

It cannot be claimed that the SIP is always more advantageous than a lump sum investment. It all depends on the course of equity prices which form the basis for computing the price of units.

If over the total period of holding, the prices have been generally declining, the SIP would cause a loss: the redemption amount (based on NAV at the end) paid to the investor for the accumulated units in his/her account would be less than the total cost. In the opposite case of rising prices, the SIP would be advantageous.

Example

Consider the following simplified example: Monthly investment is Rs. 1000 for the next 12 months. The amount is invested each month immediately in units of an equity scheme at the ruling price of units.

Assumption-1 (Declining Prices): The price per unit is Rs. 16 for first 8 months and Rs 10 per unit for last 4 months. (This is a simplification. The price for each month would ordinarily be different.) Under this assumption, against Rs. 1000 per month paid by the investor, the number of units purchased will be 500 in the first 8 months and 400 in the last 4 months. Thus the total number of units purchased over 12 months will be 900 at a cost of Rs. 12000. The redemption of the accumulated units is done always at the closing NAV. As per our assumptions, the accumulated units are 900 and will fetch only Rs. 9000 at the closing NAV of Rs. 10 per unit. The investor suffers a loss of Rs. 3000 on the total amount invested (Rs. 12000 – 9000).

Assumption-2 (Rising Prices): The ruling prices of units are reversed, being Rs. 10 for first 8 months and Rs. 16 for last 4 months. The number of units bought for the investor will be 800 in the first 8 months and 250 in the last 4 months. The total number of units accumulated over the 12 months will be 1050 for Rs. 12000. These 1050 units will fetch Rs. 16800 at the closing price of Rs. 16 per unit. There is a total gain of Rs. 4800 for the investor (Rs. 16800 – 12000).

The example given above brings out that the crucial factor is how the ruling price behaves over the period of SIP. In the real world, no one can predict the pattern of prices which will prevail in the future over the next 12 months or a longer period of some years. The most advantageous situation for the investor is when his/her over-all buying cost is the least  and the realisable price on completion of the investment plan is the highest.

An investor, who joins the SIP at a wrong time (i.e. when the equity prices are all-time high), will be in an unfortunate situation unless the prices rise further in the future. Thus, we see that the averaging of price over the period of SIP does not always insulate the small investors against the market’s volatility.

In the case of SIP, the possibility of loss can be avoided by not starting at the wrong time (i.e. when equity prices are too high). We should bear in mind the fact that the Indian stock market is far more volatile than the developed markets, like U.S. and U.K. If we look at the movements of BSE Sensex, a significant fall or rise of 20-25% within a few months is fairly common. The SIP provides a very imperfect solution to the problem posed by market’s high volatility.

Caution needed

The investor should not take it for granted that SIP is always advantageous. The price level at the starting point is particularly important, as illustrated above. The price level at the end of the period chosen is also critical. The rigidity of most SIP schemes can be both inconvenient and disadvantageous to the investors. The investor should avoid a situation of forced redemption of accumulated units at
unduly low price by building some flexibility in the choice of redemption date.