Investing through a Systematic Investment Plan (SIP) is a popular choice for many individuals looking to build wealth over time. However, it’s crucial to have a clear understanding of how SIP works and what to expect, especially in terms of returns over different time horizons.
The emphasizes the need for realistic expectations when it comes to SIP investments. Many people have heard stories of individuals who invested in SIPs and achieved substantial wealth, but the reality may be different from these anecdotes.
One of the common misconceptions is the belief that SIPs work like magic, and your money will double in a short time, such as 6 years, based on the Rule of 72. The Rule of 72 suggests that with a 12% annual return, your money should double in 6 years. However, the blog points out that this rule is more applicable to lump-sum investments, not SIPs. In SIPs, you contribute regularly, and the power of compounding works on the total invested amount.
A practical example using a SIP calculator. It demonstrates that if someone invests 10,000 rupees per month for 6 years with a 12% annual return, their total investment would be around 7.2 lakhs, and the expected amount would be approximately 10.56 lakhs. In this case, the money doesn’t double in 6 years as per the Rule of 72.
However, the true magic of SIPs becomes evident when you extend the investment horizon beyond 10 years. Over a longer period, the compounding effect starts to kick in. For example, with a 20-year investment horizon, the returns show a more significant impact, and the total amount reaches around 1 crore, demonstrating the power of compounding in SIPs.
The takeaway from this analysis is that SIPs are indeed a valuable investment strategy, but they work their true magic over an extended period. Short-term expectations of doubling your money in a few years may not be realistic for SIPs. Therefore, it’s crucial to have a long-term perspective and understand that SIPs can significantly grow your wealth over time, especially when you allow them to compound for more than a decade.
First, the importance of understanding the real magic of SIPs, which typically occurs over extended investment horizons. It counters the misconception that SIPs work like magic and double your money in a short period. It emphasizes that the true power of compounding in SIPs becomes evident when you allow it to compound over more than ten years.
However, it also introduces a crucial aspect that many investors tend to overlook—the impact of inflation. While it may seem like you’re accumulating substantial wealth, the purchasing power of that wealth decreases over time due to inflation. Therefore, the blog suggests that if you account for inflation-adjusted returns, the accumulated amount may be much lower than expected. This adjustment can significantly change the perceived value of your investments.
The notion is that SIP investments can help fulfill life goals and provide financial security. It highlights that while SIPs are indeed a valuable way to save and grow money, they may not necessarily lead to life-altering changes within ten years. Instead, they serve as a robust method to accumulate wealth and secure your future or that of your children.
It underscores the importance of checking exit loads, which are fees incurred when you withdraw funds before a certain period, typically a year. High exit loads can eat into your returns and should be considered when making investment decisions. It goes on to explain how to check for exit loads using a mutual fund screener and stresses the need for investors to be aware of these details.
Additionally, the a distinction between regular and direct plans of mutual funds. It highlights that direct plans typically have lower expense ratios compared to regular plans. The expense ratio represents the costs associated with managing a mutual fund and can affect your overall returns. Therefore, the choice between a regular and direct plan can have an impact on your SIP returns.
The expense ratio, as explained in the blog, is the percentage of your total invested amount that mutual funds deduct to cover their operational costs. This deduction happens before your money gets invested, resulting in a slightly lower initial investment amount. For instance, if you invest 1 lakh rupees in a mutual fund with an expense ratio of 2.5%, they will deduct 2,500 rupees upfront, and your actual investment will be 97,500 rupees.
We emphasize the fact that direct plans usually have lower expense ratios compared to regular plans. It encourages investors to examine their chosen mutual funds and identify whether they have opted for direct plans, which can lead to higher returns due to reduced expenses.
It provides an example of small-cap mutual funds, showcasing the variation in expense ratios among different funds within the category.
The different plans available within mutual funds, specifically the growth and bonus plans. It explains that in the growth plan, dividends earned are reinvested back into the fund, helping to boost overall returns over time. On the other hand, the bonus plan distributes dividends to investors, providing them with immediate income from their investments.
The concept of dividends is discussed, where companies share a portion of their profits with their shareholders. Similarly, mutual funds also receive dividends from the stocks they hold. In the case of the bonus plan, these dividends are distributed to the mutual fund investors, giving them income in the form of dividends. In contrast, the growth plan reinvests these dividends to buy more shares, which can lead to higher long-term capital growth.
It provides an illustrative example to emphasize this point. Suppose an individual starts their SIP in January 2023 and plans to withdraw in February 2024. Even though the investment period is over a year, exit loads are applied differently to each installment based on how much time has passed. The first SIP installment (January 2023) is exempt from exit load. The subsequent ones are subjected to it.