Systematic investment plans (SIPs) from mutual funds have become very popular these days. But there are certain things that investors should keep in mind when starting an SIP.
a) Do not start an SIP on a mutual fund scheme just because it has 0% entry load: Some new mutual funds, in order to get investors to invest into their schemes through the SIP route, have not been charging any entry load.
Mutual funds generally charge the investor an entry load of 2.25% for investing into their scheme. What this means is that for every Rs 100 that the investor invests in the mutual fund scheme only Rs 97.75 is actually invested. The remaining money, i.e. Rs 2.25 goes towards meeting expenses, primarily distributor commission.
Investors should not start an SIP on a scheme just because it is offering a 0% entry load. Most of the mutual funds having a 0% entry load for investing through the SIP route are new fund houses, which haven't been in the market for a long period of time.
Given this, they do not have enough experience in dealing with various stages of the market. Also more than a scheme having a 0% entry load, the investor should look at performance of the scheme over a period of 3 to 5 years and invest in those schemes through the SIP route.
Past performance of a scheme obviously does not guarantee future performance, but is any day better than investing in a scheme which does not have any performance.
b) Do not stop the SIP when markets are not doing well: Some investors have a tendency to start an SIP and then stop it when the markets are not doing well. This goes against the entire purpose of investing through the SIP route.
Investing through the SIP route brings rupee cost averaging into play. Rupee cost averaging ensures that investors limit their purchases when the markets are doing well and buy more when the markets are not doing well.
This ensures that the average price of a single unit comes down if the individual keeps buying even when the markets are not doing well. Also, the quintessential principle of investing is to buy low and sell high. But most individual investors decide to enter the markets only when the markets are doing well and hence go against the principle. Rupee cost averaging automatically ensures that investors follow this principle.
Let's try and understand why it is important to continue the SIP when the markets are not doing well through an example:
An investor decides to invest in a scheme through the SIP route. He invests Rs 10,000 every month. In the first month of his investing the net asset value of the scheme is Rs 100. Assuming that there is no entry load for the ease of calculation, at an NAV of Rs 100, the investor buys 100 units.
Now the next month the markets fall and the NAV of the scheme is at Rs 80. At this NAV, the investor will be allotted 125 units. The investor now has 225 units. The investor has invested Rs 20,000 over a period of two months. Given this, the average price of a single unit is Rs 88.89 (Rs 20,000/225 units).
Now the NAV of a single unit currently is Rs 80, hence the NAV now needs to rise by Rs 8.89 ( Rs 88.89 - Rs 80) for the investor to be in profit zone.
At an NAV of Rs 88.89, the total value of the investors investment will stand at Rs 20,000 (Rs 88.89 x 225 units). This is the amount he has invested over two SIPs.
If the investor had stopped investing after the first SIP then the average price of a single unit would stay at the first NAV of Rs 100. Hence the price of a single unit needs to rise by Rs 20 (Rs 100 - Rs 80) from the current NAV of Rs 80, for the individual to be in profit zone again.
The example clearly shows us that when the investor continues with the SIP, the average price of a single unit is lower and hence the chances of being in the profit zone again are better. If the investor stops the SIP, then the average price of the single unit is Rs 100. Hence, the chances of the investor of being in profit zone are better if the investor continues with the SIP as the NAV of the scheme needs to rise by a lesser amount.
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