What is an SIP and how does it work?

Beginners in the field of investing and people who ever even thought of investing must have come across the term 'SIP'. This term is so popular that it has over 1.3 lakh average monthly searches on Google. Definitely, SIPs must be advantageous for investors. So what is an SIP and how do SIPs in mutual funds work? Here we tell you all about it.

The full form of an SIP is systematic investment plan. Time and again, Value Research has focused on the importance of investing regularly and staggering your investments in equities. For the same reason, we have been a strong advocator for SIPs since time immemorable. Investing in mutual funds through the SIP route helps investors to average their cost of investments. Also, it helps in inculcating a habit of investing as each month, a portion of your salary is deducted from your account and invested. It also goes well with your money cycle - you earn every month, you spend every month and you invest every month.

An investor can choose a particular fund to invest in and set a particular amount that shall be deducted from the bank account on a specific date each month. While the default tenure of the SIP while enrolling for one may be perpetual, the investors have the option to choose the tenure of the SIPs while enrolling. What remains noteworthy is that each fund has a mandate of minimum number of instalments to be paid while enrolling for an SIP. This is generally six months for majority of funds.

How do SIPs work?
When an investor enrols for an SIP, a fixed amount is deducted from their bank account at a specified date each month. From this money, the units of the funds are purchased at the applicable NAV (net asset value) which then earn returns based on the portfolio of stocks that the funds hold. In case your SIP instalment is due on the days when the market is down, you are able to purchase more units of the fund. Likewise, if the market is on a rise, you buy lesser units. Hence, the cost of your investment is averaged out by investing through SIPs. It also helps you avoid capturing the market at a high.

Now even when your SIPs stop, your investments continue to move in tandem with the market and the performance of the underlying securities. This continues until you decide to redeem your investments.

The gains on mutual fund investments are taxed only on redemption, i.e., when you sell them. They are taxed as capital gains. One must note that for the purpose of calculating capital gains, the holding period is calculated separately for each unit on the basis of their SIP date. For the same, FIFO (first in first out) method is followed. As per this method, the units purchased first are deemed to be sold first.

For SIPs in equity funds, for each instalment that is held for more than 12 months, the capital gains beyond Rs 1 lakh are taxed at 10 per cent. For the ones sold within a year, they are taxed at 15 per cent.

Suggested read:
Mutual fund redemption and taxation
Why SIPs score over lump sum investments?