A systematic investment plan, or SIP, is a popular financial tool that allows investors to make payments on a regular basis and save funds for the future. In this article, we will describe what SIP is and how it works in practice. You will also see the main benefits of SIP and learn how to invest in it, particularly how to do SIP in stocks.
What is a systematic investment plan (SIP)?
Many people interested in banking heard about SIPs, but not all know what the full form of SIP is. The full form of the SIP abbreviation in mutual funds is a “systematic investment plan”. This is a plan according to which investors can make regular payments into trading or retirement accounts and mutual funds, chosen according to their aims and preferences.
A systematic investment plan (SIP) helps to invest regular amounts and get benefits from dollar-cost averaging (DCA). Using a DCA strategy, investors make regular equal payments and can accumulate significant funds in the future, building their investment portfolio and capital.
According to SIP, a fixed and predetermined amount of funds is deducted from an investor’s account regularly, for example, monthly. A SIP differs from other financial instruments, for instance, from lump sum investment. With it, you spread the total investment over time, dividing it into small regular amounts. Therefore, investing with SIPs implies a certain level of financial discipline.
How do SIPs work?
Systematic investment plans are one of the most popular options for investing in mutual funds and other investment companies. With SIPs, you can invest small amounts over a longer period rather than feel the effects of big lump sums at once. Usually, SIP means making regular payments, for example, on a weekly, monthly, or even quarterly basis.
The main principle of systematic investing is simple. According to this strategy, you regularly purchase stocks or other securities of a chosen fund or other investment. With the concept of dollar-cost averaging (DCA), you constantly buy the same fixed-dollar amount of stocks regardless of their current price. This means that in different periods you purchase various amounts of shares at different prices, although according to some plans, you can buy a fixed number of securities.
Note! The investment amount is fixed and does not depend on prices, so investors buy more stocks when prices fall. And vice versa, when the market rises, investors purchase less.
By substance, SIPs can be regarded as passive investments because you chose the plan at the start. After that, you continue to invest automatically and regularly, regardless of the performance. For this reason, you should monitor your SIP carefully.
According to the DCA approach, it is generally assumed that with the flow of time, the average stock price declines. So, if you invest with this approach, you can reduce your investment cost. However, there may be stocks whose prices can rise dramatically, and you should be careful. In cases when prices rise, you will spend more using SIP than if you bought all at once.
In general, the DCA approach is effective because it eliminates investors’ reactions to market fluctuations. For example, when there is good news for the company, its stock prices become to rise. As a result, investors try not to buy securities during such periods.
On the contrary, when there is some negative news and prices fall, market participants may consider buying more stocks than they initially wanted. From a long-term perspective, such an impulsive approach may be ineffective, being the total contrast for dollar-cost averaging.
SIPs vs. DRIPs
Often, investors use additional income to purchase more of the same stocks using a dividend reinvestment plan or DRIP. Generally, reinvestment means using earnings from securities to buy more amount of them. For this, the brokerage firm or agent does not send the check for dividends to the investor and uses these earnings for stocks purchase in the investor’s name.
Dividend reinvestment plans are also automatic. In the beginning, when an investor opens an account, they decide how to use the dividends, and reinvestment is among other options. Therefore, the stockholders can regularly invest in a company’s stocks for the long term. Usually, DRIPs do not assume commissions because, in this case, brokers do not participate in the trade.
In addition, for some DRIPs, there is also an option to buy an additional amount of shares directly with a discount from 1% to 10%. In these cases, there are also no fees.
Note! DRIPs are flexible and allow investing various amounts depending on aims and available finances.
Advantages of SIPs
Systematic investment plans have many benefits. The first is their relative easiness. At the start, you need to decide how much you want to invest and how frequently these payments should occur. After that, you just need to monitor your investments from time to time.
In addition, since you use DCA, your investments do not depend on your emotions. This is the second main advantage of SIPs. Moreover, you reduce the level of uncertainty and, therefore, risk levels that are connected with investments in shares and bonds.
In addition, since with SIPs, you need to invest certain amounts regularly, it develops your financial discipline. Even if SIP is funded automatically, you need to be sure that there are enough funds in your account and that you can still make investments.
Summarizing all the mentioned above, the main advantages of SIPs are:
- Easiness and the principle “Set it and forget it”.
- More financial discipline.
- Fewer emotions in investing decisions.
- Lower risks compared to other types of investments.
These are only some of the SIPs advantages that we would like to mention.
Disadvantages of SIPs
Together with numerous advantages, SIPs have certain limitations. One such disadvantage is that SIPs usually have a long term. Therefore, they require a long-term commitment, sometimes up to 10 or even 20 years. If an investor wants to quit the program, penalties and other payments will appear. Sometimes the total amount of them may be up to 50% of the initial investment. Usually, the penalties are bigger for the first several years, and then their amount constantly reduces with time.
SIPs can also be relatively costly at the start. For example, you may spend up to 50% of the first year’s investments on the creation and opening of the plan. In addition, there may be other charges applicable, for example, mutual fund fees.
In summary, some of the main SIPs’ disadvantages are:
- Long-term commitment to the investment plan.
- Sometimes, significant expenses at the start.
- Penalties for early withdrawal of investments.
However, despite certain limitations, SIPs are still very popular among investors.
What is the meaning of SIP in a real-life example?
Many well-known mutual funds and brokerages, for example, Fidelity, Vanguard Investments, T. Rowe Price, and others, offer SIPs to their clients. Systematic investment plans can be set up to be funded manually or automatically regularly, e.g., monthly or quarterly, and investors can choose the preferable option. To sponsor a SIP, there is a need to have a liquid account.
A real-life example will help you understand the meaning of SIP better. For example, T. Rowe Price Company has a so-called “automatic buy” option for SIPs. The initial investment for account establishing is usually between $1000 and $2500. And after that, investors can make small contributions of around $100 every month. This option is designed for both IRA and taxable accounts, and automatic payments can be made directly from a bank account or paycheck.
We hope that from this article, you learned all about the meaning of a systematic investment plan (SIP) in mutual funds and the share market. We answered how does SIP work and provided some real-life examples, so you could better understand its meaning.
However, you must remember that investments are always connected with a certain level of financial risk. A systematic investment plan is an efficient tool, but it requires special knowledge. So, you should evaluate your financial goals and readiness to bear the risk of losing all or part of your investment.