Systematic Investment Plans offered by mutual funds are a great way to build wealth over a long period of time.

If you are a seasoned investor, you probably know that.

But do you know how SIPs are successful in increasing wealth?

Well, we’ll reveal the secret.

It is a mathematical concept called compound interest. (Trying to remember high school Mathematics?)

</a Don’t bother. In this article, we will enunciate the concept for you. In the finance domain this concept is also referred to as the power of compounding. Regular investments over a long period of time have historically been proven to generate great wealth at a healthy and high rate of growth. In the words of Albert Einstein, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” The concept states that as your money remains an investment over the years, interest is earned not only on the principal, but also on the amount of interest. This eventually creates a system of interest on both principal and interest. >
Also Read: 
13 Things You Need To Know About SIP

What is an SIP?

SIP stands for Systematic Investment Plan. It is an organized way of investing in mutual funds of one’s choice, usually at fixed time intervals.

Generally, SIP allows for a certain amount of money, decided by the investor, to be automatically deducted from the investors account and invests it in a mutual fund of the investor’s choice.

Depending on the NAV for the day, the amount of SIP is allocated towards buying certain units of the mutual fund.

This process repeats every month automatically without the interference of the investor. Thereby, saving time and cost of the investor and ensuring regularity.

An important benefit of the SIP scheme is the benefit of rupee-cost averaging over long periods of investment.

Since mutual funds are purchased at different rates every time you pay the SIP installment, the investor benefits from the power of compounding and rupee-cost averaging.

What is compounding?

The concept of compounding can be well understood by comparing it with the snowball effect.

As we roll a small-sized snow ball down a hill, it continuously picks up snow on its way down.

By the time it reaches the bottom of the hill, it becomes a larger snow boulder form a small snow ball.

The snowball can be said to have compounded on its way down the hill. As it goes down the hill, the snowball packs more and more snow; getting bigger in the process.

The snowball effect is a metaphor for the mathematical phenomenon called compounding.

The word compounding means that every year interest is calculated on the total amount of money accumulated by the end of that year, which includes the principle and the interest.

Since interest continues to get added to the principle, compounding usually generates better results over a long period of time.

In order to understand the concept of compounding with more clarity, let us look at a very simple example.

Let’s assume, a 25 year old starts investing ₹ 1 per month at a 10% rate of return till he reaches 65 years of age. At the end of the 40 year period, he will have a sum of ₹ 6,324.08.

On the other hand, suppose a 30-year old person starts investing ₹ 1 per month at a 10% rate of return till he reaches 65 years of age will have only ₹ 3796.64.

We can see from this example that despite the amount of investment and return rate being the same, only a difference of 5 years amounted to a difference of more than 50%.

This is the magic of compounding!

At 14%, any investor will have twice as much wealth than someone who starts investing just 5 years later.

This difference grows exponentially as the number of years of investment increases.

Also Read: Best SIP plans for high returns in 2018

SIPs and Compounding

Investing in SIP enables money to work in order to make more money. The phenomenon of compounding is the catalyst to this process.

One of the biggest advantages an investor gets out of investing in a mutual fund systematic investment plan is that, it has the power to generate wealth with relatively small regular savings.

SIPs bring out discipline in the investing process. It enables investors to invest regularly, without fail, irrespective of the short-term performance of the fund.

Investment into mutual funds via the SIP mode, for a long-term investment horizon, overcomes the problem of timing the market.

Remember, the essence of compounding is time. Which means, staying invested in the market, through ups and downs alike.

Conclusion

Compounding is truly a life-changing phenomenon.

It is very basic, yet extremely important to implement while investing in general and mutual funds in particular. Time is money, literally.

Compounding helps your money make money, in the sense that over a long period of time, interest is earned not only over the principal amount invested but also on the interest.

However, all investors, existing and prospective, must be aware of the fact that investment in mutual funds and equities alike, entails risk.

Therefore, all decisions of investment must ideally be guided by the investment objective of the investor.

The return expectation and risk appetite of the investor are important considerations which must be evaluated before investing.

You, as a human are bound to have aspirations, and that’s the beauty of humanity.

Humans tend to work hard and dream bigger so that they and their loved ones lead a happy and satisfactory life.

Short-term goals can be anything ranging from vacation to home renovation to buying a car or even an iPhone X. Long-term goals are more luxurious and could range from purchasing property to retirement planning to kids education and marriage.

If you carefully observe, you would see that these goals require a different approach, planning, cost, and comes with different timelines. Thus, each of these objectives require meticulous but individual planning.

In this blog, we seek to discuss the advantage of goal planning and how you can achieve your goals if you start at the right time.

It goes without saying that there are numerous investment options available in the financial market that one can choose from.

One Size Doesn’t Fit All

So, it is not necessary that if an investment is suiting me, it will suit you as well.

Depending on a person’s financial goals, time horizon, risk-taking ability, the investments that are suitable for him/her would differ.

In addition to the above, it is also essential to take into consideration, how to invest the sum of money – Lumpsum mode or Systematic Investment mode.

Let us Now Discuss More About Systematic Investment Plan (SIP)

SIP has been by far the most used term in the past.

SIP is the simplest investment mode under which a systematic and disciplined investment is made in an instrument at a regular interval. The investors in SIP, assigns a fixed sum of money regularly on a weekly, monthly or quarterly basis in his/her pre-selected instrument.

Besides inculcating a habit for savings, there are other benefits of SIP as well that make it one of the best sought after investment mode. Check out –

1.Convenience

SIP is convinient

SIPs are convenient and straightforward to set up. All you are supposed to do is pick a scheme, finalize the amount you wish to invest in, select the date on which you want to invest, and you are done.

The money gets debited from your registered bank account on that day every month (assuming you chose monthly option).

2.Flexible

SIP and flexibility go hand in hand.

You must be wondering if SIP is so convenient and robust, is it affordable? As a general perception says, good things come with a premium.

But do not worry, you can start to by as low as Rs.500 per month (that’s like cutting down on one Marlboro per day). Further, SIPs can be started, stopped and resumed anytime as per the individuals’ need.

Now you must be wondering if you have to visit a mutual fund office every time you decide to tweak, or you have to fill tedious forms.

But no, gone are those days when you used to fill forms. Now you can do all these online without having to visit physically.

3.Discipline

SIPs, as highlighted above, inculcate discipline in an investor and they remain invested in the market for some time.

4.Rupee Cost Averaging

With SIPs you don’t have to time the market. Anyways, timing the market isn’t possible. A wise investor accepts this fact well in advance and thus looks out for ways to make investing fruitful and beneficial.

One such technique is rupee cost averaging, in which an investor seeks to average out the cost of investment by investing regularly irrespective of the levels at which the market is hovering.

The strategy of investing regularly in both upmarket and downmarket, results in averaging out the overall cost and thus, eliminates the need of timing the market which is anyways impossible to do.

5.Power of Compounding

One of the most significant benefits of SIP is the power of compounding.

In this, the sooner you start better it is for you. This is because, over time, your initial investment and accumulated gain, both tend to provide additional returns and it keeps amplifying.

Will India's GDP grow to 7.3%

It could take you five years to double, but the next double would happen faster, due to compounding.

After discussing the basics of SIP, let us now see with a real-life example how SIPs helps you to achieve goals in the long-term.

Case Study – Raj and Education planning for his daughter

Raj is a 35-year-old individual staying in Pune with his wife and daughter.

Raj’s daughter is seven years old now. He is looking to provide an excellent education as she has been excelling in school. He plans to send his daughter in IITs and IIMs but is concerned of the fees of these elite institutes.

Raj found that the cost is Rs.15 Lakhs currently. So, should he aspire to save Rs.15 lakhs?

The answer is NO.

Rs.15 lakhs is the cost today, and tomorrow it will increase due to inflation.

So, the first step is to find out how much will he require in 2029 when he needs to start spending on higher education?

This is computed using future value. We find out that Rs.15 lakhs today will be equivalent to nearly Rs.27 lakhs after ten years.

So, Raj should invest in a manner that he accumulates Rs.27 Lakhs in 10 years.

Using Groww calculator, we find that he should be investing Rs.8857 per month in mutual funds. This process will help him accumulate Rs.27 lakhs in ten years (see below)

Source: Groww Calculator

Why 18% in the Above Case?

Raj has been a conservative investor and is not looking to invest in high-risk small-cap funds. His age is not very attractive at 35 years and he has dependents to take care of and liabilities to serve.

Thus, his risk appetite is moderate.

The following, we believe, could be an ideal portfolio for Raj:

Category Fund % Allocation 5 Year Return Groww Rating
Equity: Large Cap ICICI Prudential Bluechip Equity 25% 16% 5
Equity: Mid Cap Axis Midcap Fund 20% 22% 5
Equity: Multi Cap ICICI Prudential Multicap Fund 30% 18% 5
Hybrid: Aggressive ICICI Prudential Equity & Debt Fund 25% 17% 5

Please note, the fund selection, allocation to an asset class, etc. may change depending on the risk appetite of the person. Risk appetite is in turn dependent on the age, income, liabilities, dependents, etc.

What Is Risk Profile? How to Asses Risk? Here’s All You Need to Know About Risk Appetite

Thus, as final words, we say that its time you give yourself and your family a financially free lifestyle.

Think Big, Think SIP!

Also Read: When is the right time to invest in lump sum and SIP?

Happy investing!

Disclaimer: the views expressed here are of the author and do not reflect those of Groww.