How does SIP Work?
First, let’s understand the process of SIP. Once a person took a SIP plan, the amount and frequency of investment are decided as per the scheme opted. Then the money invested is used to purchase securities (say equities, Debentures, bonds, money market instruments, etc termed as ‘units’), according to the existing Net Asset Value (NAV) at that time. Such investing decisions are taken by professional fund/portfolio managers of the Mutual Funds. As SIP is recurring in nature, the number of units held by the investors increases with time and so does the value of an investment. However, SIP and Mutual Funds are subject to market risk and do not promise an increase in investment. Sometimes due to adverse market conditions investment value may go down.
*Net Asset Value (NAV) denotes the performance of a particular scheme of a Mutual Fund. NAV can be defined as the market value of all the securities (equities, bonds, money market instruments, and other securities) held by the scheme.
Secondly, understand the Principles on which SIP works:
(A) Power of Compounding: The power of compounding can make a small investment yield a significant return in long run. Under this interest earned on the principal amount is re-invested, to sum up the amount and get a maximum benefit of investment later. The investment made for longer durations yields greater returns.
(B) Rupee-cost averaging: Rupee-cost averaging is a technique used by investors to reduce the impact of market volatility on their investments. Rupee-cost averaging helps them to purchase more units of an investment when prices are low and fewer units when prices are high, this eliminates the impact of short-term fluctuations in the market and reduces the average cost of the investment.