Benefits of a systematic investment plan:
A systematic plan (SIP) is a very smart way of investing in the stock market. It is a way of making regular investments in the stock market over regular time frames e.g., weekly, monthly, quarterly. The amount to be invested is entirely up to the investor. The greatest advantage of a systematic plan is that it helps in Rupee cost averaging. In other words it takes the element of market timing out of the market. You simply buy more shares when the market goes down and buy less when the market stays up.
There are some specific advantages of a systematic plan:
a)They help the investor to accumulate significant wealth over time.
b)Helps in Rupee cost averaging.
c)Takes the element of market timing out of the investment process.
d)Helps reduce risk.
The benefits of a SIP can be understood by comparing a SIP to a onetime investment. Let us compare a Rs. 12 lakh one time investment to a monthly SIP of Rs. 1 lakh. In the event the market declines 10% as soon as the investments are made:
A 10% loss on the one time investment of Rs. 12 lakhs will result in a loss of Rs. 1.2 lakh which is 10% of the invested capital. On the other hand as only Rs. 1 lakh is invested under the SIP a loss of 10% will results in a loss of Rs. 10,000 which works out to 0.83% of the total capital. Thus the SIP has significantly lowered risk.
Now let us look at an SIP in an exchange traded fund (ETF) on the Nifty Index to understand further the advantages of an SIP. Here we will use data from the year 2008 when a recession occurred and financial markets were greatly depressed.
Using the earlier e.g. of 12 lakh invested, If the entire amount was invested on Jan 1, 2008 then the observed loss =(2959-6139)X100/6139 = 51.8%. Capital Lost as of Dec 31 2008 = (0.518)X12 = 6.22 lakh. If a capital allocation of 1 lakh / month was done instead, the weighted average purchase cost is calculated as (6139+5137+5224+4735+5166+4870+4041+4333+4360+3921+2886+2755+2959)/12 = 4711. The Loss now observed = (4711-2959)*100/4711 = 37.2% vs 51.8% if everything was invested upfront. The Capital loss incurred = .372X12 = 4.46 lakhs vs 6.22 lakhs if everything was invested upfront. The loss was significantly reduced by 1.76 lakhs. As of Oct, 09 the markets recovered and the Nifty was trading at 5180, This represents a gain of 10% from the Rupee cost averaged price of 4711 when compared to a loss of 16% if everything was invested upfront at the year opening price of 6139.
The above example demonstrated the benefits of an SIP done with a Nifty ETF. SIP's can be done on most individual stocks and mutual funds. Thus the investor is not only able to Rupee cost average his investment, he does not have to worry about the ups and downs in the market that even professional investors have difficulty in figuring out. He also considerably lowers his risk and ends up building significant wealth over time.