Why SIP is a good way of investing? “Concept of rupee cost averaging”

May 30, 2022

There is no market which is always on the rise or going down for ever. Markets are always choppy and rise gradually over a period of five to ten years.

Choppy Market

Many a times markets have gone up & down and ended up at same level or even below over a period of three years. A lumpsum investment wouldn’t help but a SIP would have given profits.

Bullish and Bear Market

Even if the markets are bullish over three years, it would have still gone through ups and downs. Both SIP and lumpsum would work. In such markets most first timers would get carried away and put in additional lumpsums. But markets always teach lesson and might become bearish and choppy for the next three years. Here again lumpsum will fail miserably where as a SIP would have fared very well.

Long time investors always say that many people will come and go but only a few will remain. It is true that first timers will lose hope and never come back to the market. It is important not to time the market and look for the right time to invest like a speculator or a trader.

There is no good or bad time to invest and think like an investor and not a speculator. With SIP any time is good time and don’t waste too much time hunting for that one best mutual fund. Because there is no fund which will always give profits.

What is SIP?

Systematic Investment Planning (SIP) is a popular method of investment. It involves investing a specific amount every month consistently over a time period. SIP works on the principle of rupee cost averaging. With disciplined investment, it can help in mitigating the risks of mutual funds in a fluctuating market.

SIP is a good way of applying rupee cost averaging concepts for investing in equity instruments. First-time investors may not have the expertise and knowledge to track the market constantly, which is why investing via the SIP route is recommended.

Concept – Rupee Cost Averaging

The idea behind rupee cost averaging is to average out the prices at which you buy units of a mutual fund. Stock market volatility reflects the ups and downs of the economy and is part of equity investment. If you remember the law of demand, when a commodity is at its lowest price, more of it is purchased. When the price of a commodity goes up, the demand decreases.

This is what investing is all about. This approach guides the investor to make the best purchase at a low price and sell at a high price. When the market conditions are gloomy, you should buy more units of a mutual fund and fewer when they are rosy.

The vast majority of investors actually do the opposite. As soon as the markets rise, they begin buying and then suddenly redeem upon a crash. In the end, investment costs increase and returns decline.

In case of SIP, you can keep on investing a specific amount on a specific date of every month. In one month, the units can be pricey while on the next month, you can buy units at a cheaper rate. Even though there are market fluctuation affecting the number of units every month, the price of each unit is averaged. Therefore, even if you buy units at a high cost, it will be reflected lower when all the buying prices are averaged. This is how rupee cost averaging concept enables SIP to minimize the loss due to market fluctuation.

SIP is a great way of utilizing rupee cost averaging concept. If the market is dropping, you can buy more units. On the other hand, when the market is roaring, you may get lower units at the same amount but it helps in averaging the cost of each unit. Therefore, it is a great way to grow your wealth over a long term, say 5 years to 10 years.

Example of Rupee Cost Averaging through SIP

Suppose, a person named Barun invests Rs. 10000 as SIP in a specific mutual fund. On the first month, say January, the NAV was Rs. 100.  Let’s look into the chart to understand how the cost of each unit is affected over 6 months.

*No. of Unit= Amount/NAV

Therefore,

Average unit price = Total NAV/ No. of months

= 598/6

= Rs. 99.6, which is lower than Rs.100

Total Unit purchased = 604.01

If Barun desires to sell all the units in the month of July at NAV Rs.100, the amount would be Rs. 60401.

Suppose, Barun had invested in Lumpsum Rs. 60000 in January, he would get 600 units only. If the same is sold in July, the amount would be Rs. 60000.

Therefore, the difference is Rs. 401 for 6 months. The figures would be more if Barun had invested for 5years or more in a fluctuating market.

In a nutshell, SIP uses the principle of rupee cost averaging, which has potential for higher return than lumpsum investment.