What Is a Systematic Investment Plan (SIP) and How Does It Work?


There are many ways to go about investing in the stock market, including several ways of ensuring you make consistent contributions to your nest egg. One option that’s gaining popularity is known as the systematic investment plan, or SIP. 

With these plans, you make investment contributions in fixed amounts on a schedule over a long period of time, much like payments on an installment loan. Newcomers tend to enjoy these plans because they take the decision-making process out of the equation while generating meaningful returns on small, regular payments. 

But what exactly is a SIP, and should you invest in one?


What is a Systematic Investment Plan (SIP)?

In most cases, SIPs refer to mutual fund investments where participants invest regular payments of a fixed amount on a schedule over a period of time, rather than making one lump sum investment. While most SIPs are geared toward mutual funds, there are also systematic plans in place for trading accounts and retirement accounts like 401(k)s


Motley Fool Stock Advisor recommendations have an average return of 618%. For $79 (or just $1.52 per week), join more than 1 million members and don’t miss their upcoming stock picks. 30 day money-back guarantee. Sign Up Now

These investment plans follow a dollar-cost averaging (DCA) investment strategy, which takes quite a bit of work off the table for investors. The strategy ignores the noise of short-term volatility by making several smaller investments at regular intervals over the course of a longer period of time. 

With systematic investments, the number of shares you purchase with each contribution varies. As the price of the assets you buy rises, you’ll purchase fewer shares with your fixed contribution; as prices fall, you’ll be able to purchase more shares. Over time, you’ll end up with a pool of shares with an average cost somewhere between the low and high price during the period of accumulation. 


How SIPs Work

When you first sign up for an SIP, which can be done directly with a mutual fund provider or through a broker, you determine the mutual fund or other investment you want your money to be invested in, the amount of money you plan on investing with each contribution, and the amount of time between each contribution. 

Once your first deposit into your investment account is made, you will be issued units of the mutual fund based on the amount you invested in relation to the net asset value (NAV) of the fund. 

From there, your deposits will happen on a regular basis based on the amount and time intervals you stipulated when setting the account up. 


SIPs vs. Dividend Reinvestment Plans (DRIPs)

SIPs are sometimes confused with dividend reinvestment plans, or DRIPs, and the confusion is understandable. Both of these plans make automatic investments into your account on your behalf. However, there are big differences between the two.

Unlike SIPs, DRIPs don’t deduct money from your bank account and deposit it into your investment account. Instead, these plans capture dividends from your existing investments and reinvest them on your behalf, purchasing more shares of the company or fund that paid the dividends to you. 

Although DRIPs provide regular reinvestments over time, there’s no fixed amount of money invested, because dividend payments change from time to time. And you have to own dividend-paying assets to begin with in order for a DRIP to have any money to capture. 

SIPs, by contrast, are a way to contribute new money into investments on a regular schedule. In fact, SIPs and DRIPs work great in conjunction with one another. By adding a DRIP to your SIP, you’ll accumulate more shares over time, helping to shorten the road to meeting your financial goals. 


Pros and Cons of SIPs

There are pros and cons to everything in life, especially when it comes to making financial decisions. In terms of investing in SIPs, here are the most significant pros and cons to consider.

Pros of SIPs

If you’re considering setting up a systematic investment plan, there’s quite a bit to be excited about. After all, they remove much of the guesswork out of investing while protecting you from volatility and making your contributions automatic. Here’s what investors tend to love about systematic investing: 

  1. Volatility Protection. Because systematic investing uses dollar-cost averaging, your portfolio will be protected from significant short-term volatility. While your average purchase price won’t be at the bottom, it won’t be at the top either, giving you a fair overall cost of entry over time. 
  2. Easily Add Investing Into Your Budget. The investment amount you make on a regular basis is ultimately your decision. You can invest as little or as much into your plan as you’d like in most cases. That makes investing through these plans easy to fit into just about any budget. 
  3. Automatic Investments. Because your bills must be paid every month, you’re used to making those payments and adjust your discretionary spending to allot for them. Automatic investing results in similar activities. After a few contributions, the investments will become natural. The investments being automated helps you avoid the common hurdle of not having extra money available to invest.  
  4. Little Research Required. Picking your own portfolio of stocks, bonds, and investment-grade funds takes quite a bit of research. However, when you invest in one of these plans, the hard work is done for you by experts on Wall Street. 

Cons of SIPs

At first glance, SIPs may seem like the perfect investment option, but it’s also important to consider the downside to any financial decision. In this case, the most significant drawbacks include:

  1. High Expenses. Some systematic investments come with high expenses. Between mutual fund fees and custodial fees, you could find yourself paying almost 3%, which will significantly cut into your profitability. It’s imperative to compare your options, paying close attention to fees, before investing in one of these plans.  
  2. Less Liquidity. Although mutual funds and other investments are generally liquid, some SIPs require holding periods, and accessing your funds may come with early withdrawal penalties.  
  3. Missed Buying Opportunities. Dollar-cost averaging means protection from volatility, but it also means that you could miss out on big buying opportunities. While there’s no way to truly time the market, having your funds tied up when huge opportunities to get in on undervalued assets arise may prove to be painful. 

Should You Invest in a SIP?

There’s no such thing as a one-size-fits-all investment. Each investor will have their own unique financial goals, access to capital, and appetite for risk. Only you can answer the question of whether you should make a SIP investment. You may be a good candidate for these types of investments if:

  • You Are Risk-Averse. SIPs come with two factors that shield you from risk. They take advantage of dollar-cost averaging while generally investing in a highly diversified portfolio of stocks, making them a great option for the risk-averse investor. If you’d rather have the potential for market-beating gains in exchange for taking larger risks, there are better options available for you elsewhere. 
  • You Are Busy. If you don’t have the time or ability to research a portfolio of stocks, bonds, and other investments, it’s best to leave the investing to the pros. SIPs allow you to do so, as they’re often managed by some of Wall Street’s most well-respected experts. 
  • You’re a Long-Term Investor. SIPs are generally long-term plans that can come with early withdrawal fees. So it’s important to make sure that you’re in it for the long haul before diving into an investment like this. 
  • You Need a Plan. Many investors find comfort in plans, especially those that automate the process so they don’t have to think about it. If you’re one of these investors, SIPs may be a great choice for you. 

How to Invest in a SIP

Are you ready to jump into a SIP? Here are the steps to getting started:

Step #1: Know Your Goals

Investing should be a goal-oriented process. If you know what your goals are, you’re far more likely to reach them. Take a moment to think about what your investment goals are. Keep in mind, each SIP you find will be unique in one way or another, so some will be better equipped to help you achieve your goals than others. 

Step #2: Select a Plan

Each systematic investing plan on the market today is different. So, it’s important to take a bit of time to compare the options available to you and choose the one that’s most suitable for your investing style and goals. When making your comparison, pay close attention to:

  • Fees. Some plans come with exorbitantly high fees, while others are far more reasonable. You don’t want to get involved in a plan with high fees because those costs will ultimately cut into your earnings, limiting your growth potential. 
  • Historical Returns. Look into the returns the plan has seen over the past three to five years. If you want to go back farther, by all means, do it! There’s no shame in gathering all the information possible to make an educated investment decision. 
  • Asset Allocation. It’s important to know what you’re investing in when you make an investment. Look into what assets the plan invests in, and make sure they’re in line with your investing goals. 

Step #3: Fill Out the Forms

Each provider has its own set of forms they require to open a SIP for you. However, there’s one form all providers are required to get filled out by their customers: a know-your-customer (KYC) form. This form gives the plan provider personally identifiable information about you to ensure your contributions aren’t part of any criminal activity, such as money laundering. 

Step #4: Connect Your Bank Account

SIP investments happen through automatic bank draft, so you’ll need to connect your bank account to get started. If you purchase a SIP through your broker, you will have already connected your bank account to your brokerage account. If you buy the SIP directly from the mutual fund provider, they will ask you for your checking account number and routing number for regular contributions. 


Alternatives to SIPs

If you’ve decided that SIPs aren’t right for you, don’t worry, there are other ways to access the market while taking advantage of automatic investments. Two of the most common include:

Buying ETFs

Exchange-traded funds (ETFs) are bucket investments that pool money from a large group of investors and invest that money in a diversified portfolio of equities. These funds can be purchased through just about any broker, just like stocks. 

Many brokers allow for automatic investing, creating automatic draws from your bank account of predetermined amounts of money at predetermined intervals that are invested in the assets of your choice. Setting up automatic investments into broad-market ETFs allows you to create your own SIP without high mutual funds and custodial fees. 

Using Robo-Advisor Services

Robo-advisors have become a popular option among the millennial generation. Robo-advisors are services like Betterment and Acorns that automatically invest on your behalf. In general, these services invest in a wide range of ETFs, providing exposure to the market as a whole with little effort required from the investor. 

When setting up a robo-advisor account, you’ll generally be asked about your investing goals and capital availability. From there, the advisor will suggest a plan that will help you achieve your financial goals, which often includes regular, fixed contributions just like SIPs. 

The primary benefit of a robo-advisor over a traditional SIP is cost. Robo-advisor fees average just 0.25%, allowing you to hold onto the majority of your earnings in the market. 


SIP Frequently Asked Questions

As with any other popular financial product, there are several frequently asked questions on the topic of systematic investment plans. Here are the answers to some of the most common questions:

What is the Advantage of Investing in Smaller Installments?

Timing the market is so difficult that doing so successfully 100% of the time is considered impossible. As an investor, you don’t want to purchase a stock at the top, just before a big decline in value. You also don’t want to miss out on the power of compounding gains by leaving your money out of the market while you wait around for stocks to come down. 

Dollar-cost averaging (DCA) solves that problem. By jumping into the market immediately with a small installment, you’re able to take advantage of the power of compounding gains. However, if the value of your investments falls, you won’t take a big hit because future installments will average out your overall cost. 

How Often Are SIP Contributions Made?

Most of these investment plans are monthly SIPs, meaning recurring deposits occur on a monthly basis. However, there’s no law or rule in place that dictates when contributions must be made. The plan you choose may require weekly, monthly, quarterly, or even annual contributions. 

What Are the Costs Involved in SIPs?

As with other investment products, the fees associated with one of these investment plans depend on the plan you choose. Each provider has its own fee structure, and some providers with multiple options available may charge different fees for each. 

Nonetheless, it’s commonplace to be charged mutual fund expense ratios, which average out at about 0.71% according to research from the Investment Company Institute. Some plans also charge custodial fees, which can be as high as 2%.

Considering the fact that fees vary wildly, it’s best to do some research and explore your options before diving into one of these plans.   


Final Word

Systematic investment plans are interesting, to say the least. They make it easy for anyone to invest, regardless of their experience in the market, the amount of money they have to invest immediately, or the time they have to dedicate to the process. 

Through dollar-cost averaging and heavy diversification, these plans also provide quite a bit of protection for investors. 

If you decide to invest in an SIP, it’s crucial that you do your research. Options in the space vary wildly in both price and performance. Nonetheless, with a bit of research, you should have no problem finding a plan that fits your needs. 



Source link