Among the many types of investment plans out there is a ‘systematic investment plan’. If you have heard of mutual funds, then chances are pretty good that you have encountered this term.
This article will shed light on its connection to mutual funds, as well as explain how it differentiates from other plans.
What is it?
A systematic investment plan (SIP) is a plan in which investors make equal payments on a regular basis. They make them into a mutual fund, trading account, or retirement or annuities account, an example of this being a 401(k). SIPs allow investors to routinely save with a smaller amount of money. At the same time, they benefit from the long-term advantages that come from ‘dollar-cost-averaging’ (DCA).
For context, DCA is a popular investment strategy where an investor divides up the total amount. They do this so that it can be invested across periodic purchases of a target asset. The reason for this is to try and reduce the impact of volatility on the purchase as a whole. The purchases occur regardless of what the asset’s price is and at regular intervals. As a result, this strategy removes much of the intricate work of attempting to time the market to make purchases of equities. Specifically, at the best possible prices. It is common to refer to dollar-cost averaging as the ‘constant dollar plan’.
By using a DCA strategy, an investor will be able to buy an investment using periodic equal transfers of funds. With this, they can effectively build wealth or a portfolio as time goes on.
Mutual funds and other investment companies typically offer investors a wide variety of investment options. One of these options includes systematic investment plans. SIPs give investors an opportunity to invest small sums of money over a longer period of time. This is in lieu of having to make large lump sums all at once. A majority of SIPs require payments into the plans on a consistent basis. These can range from being weekly, monthly, or quarterly.
How it works
The key principle setting up a systematic investment plan is actually quite simple. It operates on regular and occasional purchases of shares or units of securities of a fund or other investment.
Dollar-cost averaging consists of purchasing the same fixed-dollar amount of a security. This is regardless of whatever its price may be at each periodic interval. The outcome of this is the purchase of the shares at various prices and in varying amounts. Although, some plans may allow you to designate a specific number of shares to buy. The amount that is invested is generally fixed and does not rely on unit or share prices. Because of this, an investor will wind up buying fewer shares when unit prices rise. Additionally, they will buy add more shares to their investment portfolio whenever the prices drop.
SIPs are prone to being passive investments. This is due to the fact that once you put money in, you continue to invest in it. And it will be regardless of the nature of its performance. That is primarily why it is crucial to keep an eye on how much wealth you gather in your SIP. As soon as you hit a certain amount or are getting close to your retirement, you have a decision to make. At this point, you may want to reevaluate your investment plans. Transitioning to a strategy or investment that has active management might allow you to grow your money even more. However, it would be wise to consult a financial advisor or expert to determine the situation that’s suitable for you.
Alongside SIPs, a lot of investors use the earnings that their holdings generate to purchase more of the same security. They are able to do this by way of another type of investment plan: the ‘dividend reinvestment plan’ (DRIP).
A dividend reinvestment plan (DRIP) is a program that lets investors reinvest their cash dividends. It allows them to reinvest it into additional shares or fractional shares of the underlying stock on the dividend payment date. Generally speaking, the term can apply to almost any automatic reinvestment arrangement set up through a brokerage or investment company. Be that as it may, it also refers to a program that a publicly-traded corporation offers to exist shareholders.
Reinvesting dividends basically means that stockholders may purchase shares or fractions of shares. Specifically, in companies they already own. They do not send the investor a quarterly check for dividends. Instead, the company, transfer agent, or brokerage firm uses the money to purchase additional stock in the investor’s name. In addition, dividend reinvestment plans are automatic. The investor authorizes the treatment of dividends as soon as they establish an account or first buy the stock. DRIPs allow shareholders to invest variable amounts in a company over a long-term period.
DRIPs that companies operate are typically commission-free. This is because there is no need for a broker to facilitate the trade. There are some DRIPs that offer optional cash purchases of additional shares directly from the company. Primarily at a 1% to 10% discount and with no fees. DRIPs are very flexible, so investors may invest small or large amounts of money. In the end, it all depends on what their financial situation is.
A mutual fund is a specific type of financial vehicle consisting of a pool of money. The collection of this money was by many investors hoping to invest in various securities. These include such things as stocks, bonds, and money market instruments, among other assets. The ones who are responsible for mutual fund operations are professional money managers. They designate the fund’s assets and try to produce capital gains or income for the investors of the fund. The structure and maintenance of a mutual fund’s portfolio match the investment objectives that its prospectus states.
Mutual funds provide access for small or individual investors to view professional portfolios of equities, bonds, and various other securities. Therefore, each shareholder participates proportionally in the gains, as well as the losses, of the fund. Mutual funds invest in a considerably large number of securities. The tracking of performances is typically in the form of a change in the total market cap of the fund. This derives from the accumulating performance of the underlying investments.
The average mutual fund is able to hold hundreds of diverse securities. What this means is mutual fund shareholders will garner important diversification at a substantially low price. For example, imagine an investor purchases Google stock before the company experiences an especially bad quarter. This person runs the risk of losing a lot of value because all of their dollars tie to one company.
Conversely, a different investor may buy shares of a mutual fund that just so happens to own some Google stock. When Google goes through a bad quarter, this other person loses significantly less. This is because Google is merely a small portion of the fund’s portfolio.
What’s the difference?
Oftentimes, people describe mutual funds as being a basket of stocks or bonds. It largely depends on the fund’s investment objectives. The management of this basket is by a professional with shares of the portfolio that investors make available for purchase. At each trading day’s conclusion, all the fund’s holdings receive a price. From this point comes the calculation of the fund’s net asset value. Purchases of mutual funds are possible either with lump-sum investments or through a SIP.
A SIP typically involves an investor contributing in the form of a set dollar amount on a regular basis. For example, you may establish a SIP in order to purchase $100 per month worth of ABCDX mutual fund. Each month, on the same date, you would conduct the execution of that buy order. This particular way of investing provides two key advantages: one is easy saving, the other is dollar-cost averaging.
Setting up a SIP makes it so much easier to budget for retirement, as well as reach other investment goals. When working a considerably small amount into a monthly budget, it becomes more likely that you will stay on track. Thus, it makes it easy to achieve whatever investment goals you may have. For instance, it is quite simple to commit to investing $100 per month for retirement savings. Though, coming up with $1,200 at one time may be a much more difficult task.
By buying shares of a mutual fund at a consistent pace, you can cut down the average cost per share. Market fluctuations over a period of time will likely present opportunities where share purchases are at a lower price. As you may recall, the DCA technique is a popular strategy. One that many investors use and many financial advisors recommend it.
Advantages to systematic investment plans
SIPs provide those who invest in it with a variety of benefits. The first, and probably the most obvious, stems from when you establish the amount you wish to invest and the frequency. Upon doing this, there is not much more for you to do. The funding for systematic investment plans is always automatic. Because of this, you need to make sure that there is enough money in your funding account to cover your contributions. It will also allow you to use a small portion. This way, you won’t experience the effects of a big lump sum being withdrawn all at once.
Due to the fact that you are using DCA, there is very little involvement of emotion. That effectively decreases some of the risk and uncertainty you may go through with other investments. It requires a fixed amount at regular intervals, so you are also incorporating some discipline into your financial life.
To sum up the pros:
- You set it and then you can forget about it
- It imposes discipline and avoids emotion
- It works with small amounts
- Reducing the overall cost of investments
- There is less of a risk to capital
SIPs – Disadvantages
True, systematic investment plans are capable of helping an investor maintain a steady savings program. However, these plans also have several restrictions. For example, they will usually require a long-term commitment. This can range from 15 years to up to 25 years. Investors are able to quit the plan before the end date, but they may provoke hefty sales charges. Most of the time, these charges are as much as 50% of the initial investment within the first year. The result of missing a payment could be the termination of the plan.
Systematic investment plans have a tendency of being very expensive to establish. The average creation and sales charge can go up to half of the investments of the first 12 months. Moreover, investors need to keep an eye out for mutual fund fees and custodial and service fees, if applicable.
To sum up the cons:
- It requires a long-term commitment
- Can carry massive charges for sales
- There can be early withdrawal penalties
- Potentially miss out on buying opportunities and bargains