The SIP is the best form of investing say analysts on television, or your newspaper, or your financial advisor or even articles such as this one. Ever wondered why? Read on to find out...
Basics revisited
SIP stands for Systematic Investment Plan. It means that instead of investing sporadically or in a lump sum, it is better to regularly invest a fixed amount. This will help you benefit from the averaging effect.
This averaging effect happens because you buy more units whenever the price falls and less units whenever the price rises.
For instance, assume you are investing Rs 10,000 every month. When the price of a unit falls to Rs 10, you get 1,000 units; when it rises to Rs 20 you get only 500 units.
However, if you calculate the average price of each unit, it comes to about Rs 13.3 (Rs 20,000/ 1,500) instead of Rs 10 or Rs 20.
A SIP is not necessarily restricted to mutual funds. It is a concept that can be applied to any investment.
The question now is: how do you quantify the benefits of investing in a SIP?
The 'averaging' benefit
Take a look at the charts given below. The first two charts are for an equity liked saving scheme.
The first chart shows how the rate (cost at which the investor bought units = NAV + charges) has changed in 2006. It also shows the average price an investor would have paid every month had he adopted the SIP route. The blue line is the rate at which the investor got the units, while the pink line is the average cost per unit for each month. The chart makes it clear that, even though the rate has swung wildly, the average cost per unit is fairly stable.
The chart below shows how the investor would have accumulated units over the last one year. You will notice that, as the rate goes down, he is getting more number of units and vice versa.
Statistical evidence
While the charts are self-explanatory, statistical analysis shows that the Standard Deviation (measure of volatility) for the ELSS rate over the year has been 1.47, while that for the ELSS SIP has been 0.38.
ELSS Rate Standard Deviation | 1.4723 |
ELSS SIP Standard Deviation | 0.3792 |
Power Rate Standard Deviation | 4.1790 |
Power SIP Standard Deviation | 1.3662 |
And standard deviation is...
If you are given a few numbers, and told to find their average, you can very easily do that. Now, if these numbers are more or less near to the average value, you can say that the data range is very near to the average value. To that extent, the data is stable. In case of NAV1 in the example below, the data range is 10.24 -- 15.02 (the lowest and highest value), which is relatively nearer to the mean or average value of 12.72.
For instance, if you have to calculate the average (mean) age of five children aged 32, 34, 36, 38 and 40 years, you add the ages and divide it by 5. In this example, the mean will come out to 36 (32+34+36+38+40 / 5).
However, if the data range were large on either side of the average value, it would mean that the data is fluctuating a lot. In NAV2, for example, the data range is from 22.96 to 36.43 and the mean is 29.11, which indicates high fluctuation.
2006 | NAV1 | NAV2 |
January | 11.6 | 23.88 |
February | 12.14 | 26.47 |
March | 13.21 | 30.80 |
April | 14.02 | 31.87 |
May | 15.02 | 31.88 |
June | 10.24 | 22.96 |
July | 10.89 | 25.24 |
August | 11.71 | 26.95 |
September | 12.22 | 27.81 |
October | 13.37 | 31.00 |
November | 13.88 | 33.94 |
December | 14.30 | 36.43 |
Average | 12.72 | 29.11 |
SD | 1.472 | 4.179 |
% change | 23% | 53% |
When it comes to your investments, you would like to have an instrument whose value steadily increases over time. However, since this is not practically possible in the case of stock markets (and, as a direct result, with equity mutual funds), you would like to have a scheme, where NAV has an upward trend but is not subject to wild fluctuations.
SD measures how far from the average the values sway. So, in case of huge swings, the SD will be higher. In case of low fluctuations, the SD will be lower. As can be seen above, the SD for NAV1 is 1.47, while that for NAV2 is 4.18.
Let us try to see this by the following example. We have taken the data mentioned under the columns NAV1 and NAV2. The only difference is, we have equated the first value of both the series to 100.
Now, if you observe, not only does the thick light blue line (representing the trend of NAV1) have a gentler slope than the thick light pink line (representing the trend of NAV2), the swing of the data (NAV1 � dark blue data line) on either side of the light blue line is lesser than that for the other set of data (NAV1 -- dark pink data line).
This means the scheme represented by NAV1 (ELSS) is less volatile than the scheme represented by NAV2 (of a power sector fund).
Take a look at the SD of these two data sets (base value = 100). You will notice the annual returns for NAV1 has been 23 per cent while that for NAV2 is 53 per cent.
How averaging works
Take a look at Chart 2. You will see the number of units increasing as the price falls. This is obvious, since you are investing a fixed amount every month.
When the same amount is used to buy units at various prices, then you will get more units when the price is less and less units when the price is more. This can be seen in Chart 2 where, as the NAV rises till May, the number of units bought falls. In May, as the NAV crashes, the number of units zoom up, only to steadily fall as the NAV rises till December.
So, at any point, if you wish to calculate the average price you are paying per unit, you will have to divide the total amount you have invested with the number of units you have been allotted.
Simplifying statistics
In a nutshell, this is what it means:
~ Investing in SIP reduces risk (volatility).
~ The cost per unit reduces due to averaging.
~ Extending SIP over longer periods of time in schemes that are doing well will increase the difference between the then prevailing NAV and average cost of buying.
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