An equity mutual fund SIP is one of your best bets to create wealth in the long run. But to make your SIP work hard for you, you need to take care of some of the basics. A SIP is quite suggestive. It is based on the premise that if you keep saving small bits over a period of time then it eventually grows into a large corpus. But to enable a SIP to create wealth, there are some basic rules that you must follow. Here are 5 such rules..
Start early; in fact as early as possible
That is the cardinal principle. The earlier you start, the more your principal earns returns and therefore the more your returns earn returns. That is called the power of compounding. In fact, more than the amount of the SIP and the rate of return, it is the time period that makes the biggest difference. Consider the representative chart below:
ParticularsAjitRanjitAshokVarunStarts SIP at age25303540Ends SIP at age55555555SIP Tenure30 years25 years20 years15 yearsSIP AmountRs.5,000Rs.10,000Rs.15,000Rs.20,000CAGR Yield15%15%15%15%Total SIP OutlayRs.18 lakhsRs.30 lakhsRs.36 lakhsRs.36 lakhsSIP Value at 55Rs.3.51 croreRs.3.28 croreRs.2.27 croreRs.1.35 croreWealth Ratio19.5 times10.9 times6.3 times3.8 times
One thing is absolutely evident from the illustration above that the most important thing in SIP is to start early. Ajit starts early and does the smallest SIP. Yet, at the age of 55 he has created the highest absolute wealth and has the highest wealth creation ratio by far. Compare Ashok and Varun. Both have contributed Rs.36 lakh as SIP but just because Ashok started 5 years earlier, his wealth is substantially higher than that of Varun. The moral of the story is that even if you start small, start early!
Stay loyal to your SIP and stay disciplined
Another important rule of SIP is discipline. Once you start a SIP, ensure that you do not discontinue the SIP or that you do not miss on SIP contributions. There are two aspects to this argument. Firstly, make the SIP as a necessary discipline and treat your other expenses as residual items. Unless you are able to maintain that discipline you will not be able to make the best of the SIP. If you terminate the SIP in between, then your eventual wealth creation will be grossly impacted. Secondly, your SIP is all about reinvestment of principal and returns. Hence, always prefer a growth plan over a dividend plan as the growth plan ensures automatic reinvestment in the fund.
Focus on diversified equity funds and focus on consistency
Investors are normally confused as to which fund to select for the SIP. Some investors prefer to select a higher risk sector fund or thematic fund to enhance returns. That is not exactly advisable. Your long term SIPs should always be in diversified funds. Most sector funds and thematic funds go through cycles and carry the concentration risk. You invest in mutual funds to diversify your risk and if you opt for a sector fund or a thematic fund you are going against the basic grain of diversification. When you are trying to create wealth in the long run, it is always advisable to spread your risk and that is best achieved through diversified equity funds.
Let every SIP be tagged to a specific goal to make it meaningful and measurable
Before you start a SIP, ask yourself a basic question; what is the purpose of the SIP? To make your SIP purposeful you must tag each SIP to a long term goal. For example, you can decide that two SIPs are for your retirement, one SIP is for your child’s education and another SIP is for your child’s wedding. You can have short term SIPs on debt funds for requirements like your home margin, car margin etc. The whole idea of tagging SIPs to a specific goal is that you know clearly where you want to reach. That helps you to monitor whether you are on target or not.
Monitor regularly and extrapolate in post tax terms
There are two additional conditions pertaining to the success of SIPs. Firstly, you need to monitor your SIPs on a regular basis. Are your inflation assumptions correct? Have your overestimated in your return assumptions? Is it wise to continue with equity SIP when markets are nearing their peak? These are questions to answer before you extrapolate your returns on the SIP. Secondly, always measure your SIP in post-tax terms. For example, when the Union Budget 2018 introduced a 10% flat tax on LTCG, it is likely to impact your equity SIPs in a big way. Hence you need to increase your SIP amount or reduce your target. Post tax evaluation of SIP will throw a lot more insights.
SIP is a great instrument of long term wealth creation. These are some basic rules you need to follow to make a true success of your SIP.