“Slow and steady wins the race,” they say. In a world where get-rich-quick schemes abound, this might sound like an adage from another age.
Yet studies about millionaires in the US and the UAE conclude that these people built wealth through patient and consistent investing. “No matter how great the talent or efforts, some things just take time,” said Warren Buffett. “You can’t produce a baby in one month by getting nine women pregnant.”
A systematic investment plan (SIP) is an attempt to reflect the idea that wealth building requires patience and consistency.
So, what is SIP investment? It is a method of consistently investing a certain amount of money in a selected portfolio at regular intervals.
It aims to take advantage of compound interest and remove the need for emotional investing.
In what follows, we will clarify how this concept works, its benefits, and how you can start designing yours. We’ll cover:
- What is SIP Investment: An introduction
- What is SIP Investment: The different types of SIPs
- How SIP works
- Designing a portfolio for SIPs
- Benefits of investing in a SIP
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1. What is SIP Investment: An Introduction
A systematic investment plan is an investment strategy that requires consistent investing of a certain amount of money at regular intervals. The three keywords here are “consistent,” “certain,” and “regular.”
Let’s consider an example that will clarify this concept.
Suppose Mr. A’s salary is AED 10,000. If Mr. A uses the 50/30/20 rule, he will be investing AED 2,000 every month.
Let’s also assume that he gets his salary on the 25th of every month which makes it possible for him to invest at the end of every month. Finally, suppose he subscribes to Sarwa Invest and has a diversified and personalized portfolio.
To summarize, Mr. A invests AED 2,000 at the end of every month in a portfolio created for him by Sarwa.
What Mr. A has is a systematic investment plan. There is consistency (every month), regularity (at the end of every month), a definite amount (AED 2,000), and an investment vehicle (a diversified portfolio from Sarwa).
(Given that he contributes to his portfolio every month, we can also call it a monthly investment plan or a monthly SIP)
The concept of an investment portfolio is important as it is what differentiates a SIP from recurring deposits (offered by banks and other financial institutions). The latter also involves making regular contributions of a given amount of money.
However, while recurring deposits have a fixed interest rate (which is usually low compared to what the stock market provides), the total returns earned on an SIP depend on the performance of the investment portfolio.
We will say more about investment portfolios in a bit.
2. Types of SIPs
Though there are common elements to all SIPS, they can also come in various forms. The most common types are as follows:
- Fixed SIP: A fixed SIP is one where the investor continues to invest a fixed amount. To use the example above, if Mr. A continues to invest only AED 2,000 in his portfolio, then he is following a fixed SIP.
- Flexible SIP: With a flexible SIP, investors can modify the amount they invest depending on how their financial situation changes. These changes may be permanent (higher income) or temporary (a temporary reduction in expenses).
For example, if Mr. A’s income increases to AED 20,000, 20% of his income will now be AED 4,000. If he is using a flexible SIP, he can change the investment amount to AED 4,000 whereas if he sticks with AED 2,000, he would be using a fixed SIP.
However, it should be noted that with a flexible SIP, the investment amount can also be reduced if income falls and expenses increase.
Also, the investor can change the investment amount frequently as situations require. Mr. A might invest AED 2,000 between January and March, AED 4,000 in April, AED 5,000 between May and August, and back to AED 2,000 between September and December.
- Top-up SIP: A top-up SIP allows investors to periodically increase their SIP contributions. The main difference between a flexible SIP and a top-up SIP is that with the latter, investment amounts are only increased and the increase is predetermined.
For example, Mr. A can decide to add an extra AED1,000 to his investment amount at the end of every year, perhaps to adjust to an increase in the inflation rate. The increase can also be based on a percentage (20% yearly increase) instead of a definite amount (extra $1,000).
- Perpetual SIP: Some investors have a start and end date for their SIPs. Mr. A might want to invest for just five years. This is usually the case if the investor has a specific financial goal in view – buy a house or raise capital to start a business, for example.
In contrast, with a perpetual SIP, investors start SIP without a predetermined end date. The investor can decide to stop after four, ten, or twenty years.
3. How SIP works
“Roughly 75 percent of millionaires say their success is a result of diversified, regular, consistent investing,” said Andrew Hallam, a financial journalist in the UAE.
So, why is the type of diversified, regular, and consistent investing exemplified in a SIP crucial for wealth generation? Asked differently, what is SIP and how does it grow the investments?
Regularity and wealth creation
Let’s go back to Mr. A. To see the power of regularity and consistency, let’s assume that Mr. A invests for 10 years and that his portfolio with Sarwa earns 10% annually, compounded quarterly.
Well, at the end of year 10, an SIP calculator shows that Mr. A will have AED 413,137 in his investment account. His total contributions amount to AED 240,000 while his SIP returns add up to AED 171,137.
AED 2,000 might look like an insignificant amount but with consistency, Mr. A has turned his monthly (insignificant) AED2,000 into almost half a million dirham.
If we increase the investment amount to AED 5,000, Mr. A would end year 10 as a millionaire, with AED 1,032,842 in his investment account.
Maximizing the power of compound interest
A SIP creates wealth because it taps into the power of compound interest.
With simple interest, only the money you set aside earns interest. However, with compound interest, both the initial amount and all the interest paid on that amount continue to earn interest into the foreseeable future. Compound interest, if properly utilized, creates a wealth-making machine.
One way an SIP maximizes the power of compounding is that it encourages investors to put all their investable cash at the beginning or end of every month into the market immediately (what is called a lump sum investment), rather than spreading out the same amount over a longer period of time.
Once it is the end of the month, Mr. A has to put all of his AED 2,000 in the market instead of spreading it into AED 500 invested over the next four months (what is called dollar-cost averaging).
The advantage of this approach is that the whole AED 2,000 can start earning compound interest immediately. By allowing the entire amount to start earning compound interest, this approach leads to higher returns.
Reducing average cost in downturns
One commonality between SIP and dollar-cost averaging (DCA) is that investors can lower their average investment cost in market downturns.
Let’s say Mr. A purchases a SIP mutual fund on January 31 at AED 50 per net asset value (NAV). He can get 40 mutual fund units with his AED 2,000.
If the price falls to AED 40 at the end of February, he can now buy 50 units at the second SIP installment with the same AED 2,000.
Also, given that he has now spent AED 4,000 to get 90 shares, his average cost has now reduced from AED 50 to AED 44.4. That is, you buy fewer units in market upturns and more units in market downturns.
Instead of worrying about economic downturns, SIP investors can use them to reduce average costs and increase potential returns.
Automatic investing
The regularity of a SIP also makes it easy for investors to automate their investments. As long as you are not using a flexible SIP, you can instruct your investment platform to automatically deduct a certain amount from your bank account at regular intervals.
4. Designing a portfolio for SIPs
Traditionally, investors have used mutual funds (equity funds, debt funds, and hybrid funds) as the investment vehicle for their SIPs.
However, with the advent of passive investing, investors are recognizing that mutual fund investments are not very efficient.
They charge a high expense ratio and yet fund managers do not outperform the market. “In almost every year since 2001, a majority of active funds have failed to beat the index,” according to Visual Capitalist, a financial data analytics platform.
On the other hand, passive funds (index funds and ETFs) charge a lower expense ratio, have lower risk, and track the performance of stock market indices.
ETFs are especially beneficial (compared to index funds) since they allow intra-day trading (and are thus more liquid), don’t require a minimum investment, provide more diversification options, and are mandated to be transparent about their holdings.
Thus, many SIP investors are choosing to invest in a portfolio of ETFs as an alternative to a mutual fund scheme.
If you don’t have the time or expertise to create your portfolio of ETFs, you can subscribe to Sarwa Invest where you will get a personalized and diversified portfolio that matches your risk tolerance, risk capacity, investment horizon, and investment goals.
Suppose you prefer building an investment portfolio from scratch yourself. An alternative investment option is to create a portfolio of ETFs (passive investing) or stocks (active investing) on Sarwa Trade.
Whichever path you take, the key thing for SIP is to have an investment vehicle where you will regularly put your money.
5. Benefits of investing in a SIP
Now that we understand how they work, let’s consider the main benefits of SIP:
Protection in market downturns
As we said above, when market prices fall, a SIP investor can profit from a lower average cost, picking up more shares for the same amount of money.
Takes away emotional investing
SIP investors don’t need to time the market before investing. Once it’s the beginning or end of the month (or whatever time they have selected), they just put their SIP amount into their chosen portfolios irrespective of market conditions.
If the market is up, they benefit from higher returns and if the market is down, they lower their average cost.
This method takes away emotional investing, which is the enemy of sound investing.
Time in the market rather than timing the market
Similarly, SIP investing is a way of investing that focuses on spending time in the market rather than going through the hassle of trying to time the market.
One investment strategy that tries to time the market is called buying the dip – accumulating cash and waiting for the market to fall before buying at cheap prices.
Does timing the market work? The simple answer is no.
The investor who holds on to cash waiting for the dips loses out on the compound interest they could have earned if they had invested. Furthermore, staying out of the market makes it likely that an investor will miss the best-performing days (or weeks or months) of an asset while waiting for it to dip.
SIP investors who invest now would have benefitted from the best months and reduced their average cost in the worst months.
Second, no one knows when the market has truly reached the bottom. What an investor thinks is the dip might be the beginning of further drops or the worst days (or weeks or months) of the stock. Imagine missing out on the best days only to participate in the worst days.
On the other hand, spending time in the market increases the likelihood of making money and reduces the probability of losing it.
As the chart below shows, investors who stayed only a month in the market, at any time between 1926 and 2019, had a 38% chance of losing money. At the far end, those who stayed in the market for 15 years, at any time between 1926 and 2019, had only a 0.2% chance of losing money.
Also, data between 1926 and 2019 show that the stock market goes up more than it falls.
Performance of the CRSP US total stock market index between 1926 and 2019
The investor who stays in the market will end up winning.
Said differently, investing consistently in the market without considering the current state of market volatility will be profitable in the long term. In this way, SIP offers a strategy to do so.
Disciplined approach to investing
SIPs help investors build the financial discipline they need to achieve their financial goals.
If we only invest when we feel like it, we won’t do much because spending is more natural than investing. But with an SIP, we gain control over our finances by investing consistently and regularly.
If you are a passive investor, you can even deploy automatic investing (a service available with Sarwa Invest), which ensures that your investment platform can debit a definite amount from your bank account into your investment portfolio at regular intervals.
Foster long-term investing
In a world where get-rich-quick schemes abound, SIP investing encourages investors to focus on the long term. Instead of trying to double your money in 24 hours (and end up losing it), you can patiently build wealth over the long haul.
Interestingly, the richest people in the world took this long, slow, and steady path – whether businessmen like Steve Jobs or investors like Warren Buffett.
With Sarwa, you can build long-term wealth by investing in the stock market with a SIP strategy. You can subscribe to Sarwa Invest and have us build a personalized portfolio for you based on the latest technology and insights from portfolio management. And you can build a portfolio yourself through Sarwa Trade.
Are you ready to start your journey to wealth in the UAE? Sign up for Sarwa for cost-effective, secure, and convenient passive and active investing.
Takeaways
- Systematic Investment Plans (SIPs) emphasize regular, disciplined investing over time, leveraging the power of compound interest to grow wealth steadily.
- Investors can choose from fixed, flexible, top-up, or perpetual SIPs, depending on their financial goals and changing circumstances.
- By automating regular investments, SIPs eliminate the need to time the market, ensuring investors stay invested regardless of market fluctuations.
- Staying invested for extended periods increases the likelihood of positive returns, as data shows markets tend to rise over time despite short-term volatility.