How regularly skipping SIPs beats the purpose of SIPs
Sanjeev, a 30-year working professional, always wanted to have a home of his own. He started a SIP aiming to have the amount in the next 10 years.
However, Sanjeev started skipping the SIP installments regularly to take care of some expense or the other -sometimes it was to pay for the gadget he bought and others it was to cover credit card bills. He thought not investing a few months won’t make a big difference. But you know what, it does
In this blog, we tell you regularly skipping SIPs is a big deal. But before we get that, let’s understand SIPs
The wonder investment-SIP
SIPs use the power of compounding and cost averaging to deliver handsome returns in the long term. The great physicist Albert Einstein famously called compound interest the eighth wonder of the world. In the case of compounding, the interest earned on the initial fund accumulates and starts generating earnings later.
You must be wondering, many other investment options deliver compounded returns, what is unique about SIPs? Well, SIPs combine the power of compounding with rupee cost averaging.
For illustrative purposes, we will consider the performance of Aditya Birla Sunlife Equity Fund
In the first case, Rs 5000 is invested through SIP every month. As you can see, as the NAV dipped due to market corrections, the number of units received for the same amount increased. So by the end of October, your average was Rs. 699.7/unit
In the second instance, a lumpsum amount of Rs 30,000 is invested in July. Since the per-unit cost is higher than February, the investor enters at a higher price and doesn’t get the opportunity to lower costs when the market corrects in the next few months. In this instance, the per-unit cost turns out to be Rs. 714.19
Rupee cost averaging works in tandem with compounding when you invest in a SIP. Cost averaging minimizes the impact of market fluctuations while compounding amplifies the returns. But averaging works only when you are regular with the contributions.
What happens when you are not regular?
As we mentioned at the beginning, frequently missing your SIP contributions can have a severe impact on the final returns. But why would anyone miss SIP payments? Life is unpredictable, and anyone can face a liquidity crunch, so missing an installment or two due to financial obligation is manageable. The issue crops up when investors tend to do this frequently, as Sanjeev did.
Let us take a detailed look at the impact of skipping SIP payments
The most significant effect of frequently missing SIP payments will be on your financial goals.
When you commit to long-term investment, the reason is always a life goal such as retirement, buying a house, or a child’s education. You have a target amount you need for that goal, and you assume a return percentage to figure out the monthly SIP amount.
Let’s look at Sanjeev’s goal of buying a home to understand the impact. He figured that he would need Rs. 50 lakhs at the end of 10 years to buy his house. He also found out that despite various market cycles, the SENSEX has delivered annualized returns of over 14% in any 10-year period since 1980. SIPs have displayed a similar performance over time. Based on this return assumption, and the amount he needed, his monthly SIP amount came out was Rs. 19,300.
Now suppose he misses 10 installments of the total 120 installments between the fourth and fifth year. These misses mean he will fall short of at least Rs. 6 lakhs, which means he will have to delay this goal.
The more installments you miss, the higher will be the deficit, but a delay in achieving the financial goal will not be the only impact.
Missed rupee cost averaging
The suppressed returns due to irregular contributions are due to missed compounding. But that’s one part. The returns you get can get reduced further due to missed rupee cost averaging.
As mentioned earlier, rupee cost averaging means your overall investment cost comes down as you invest through both ups and downs of the market. The result is higher returns than what you would have received otherwise. Now, skipping installments means you are risking bringing down your cost as you might miss investing at a lower price. This would mean lower returns
For ease of understanding, let’s continue with Sanjeev and assume he missed 4 of the 10 installments within a span of 16 months. We have used the NAV of Aditya Birla Sun Life Equity Fund to show the impact.
As you can see, because of skipping, he missed the opportunity to bring down is the average cost per unit. So at the end of October, his average price was Rs. 704.1 per unit while it could have been Rs. 696.9. This difference will only increase he or any investor skips more SIP installments.
Most SIPs channel investor’s money into equities. The stock market is a proven wealth creator. When you miss your SIP payments, the money that would have been invested in equities is utilized differently. The diversion of funds carries a huge opportunity cost.
We will go back to Sanjeev’s example. Although he just failed to pay 10 installments amounting to Rs. 1.93 lakhs, the difference he had in returns was around Rs. 6 lakhs. That’s around Rs. 4 lakhs loss. The loss number would be far more significant had he missed these installments in the initial years of his SIPs. So, even a few thousand rupees missed investing can mean loss of lakhs over a 10- or 15-year horizon.
By missing SIP installments, you are delaying your life goals, missing the benefits of rupee cost averaging, and losing the opportunity to get higher returns. But more importantly, you are cutting back on your savings. The regular payments that you make for your SIP are savings you are putting aside for the future rather than consuming it. When you skip a SIP payment, you essentially fail to save for the month, which could be detrimental for your financial stability in the long run.
Originally published at https://www.etmoney.com.