Investing through SIP (Part 2)

Ramesh started his SIP in 2007.  He diligently invested every month a fixed amount and was happy with his fund performance.  Suddenly in early 2008, the market started tanking and he became concerned about his investments and discontinued his SIP.  He predicted market to fall further and decided not invest further till the fall is arrested.  He resumed investing in mid 2009 when the market started rising.

Ramesh, here, made a fundamental mistake in SIP investing.  As we discussed in the last article, SIP is for disciplined investing irrespective of the market movements.  By choosing not to invest during the downturn, Ramesh lost the opportunity to purchase (more) when the prices were low.  Had he continued investing throughout 2008 and 2009, his gains would have been considerably more than the present.

Read Part 1 of Investing through SIP

This brings to when SIP do not work.

1. As considered above, it does not work if you discontinue the SIP in the period of downturn.  You realize the main benefit of SIP only when you continue investing during the downturn.
2. SIP is not a correct way to invest if your horizon is short term.  The probability of markets being unidirectional i.e. either rising or declining is greater in short term.  You may lose value if you invest for short term in declining market and in rising markets your gains will be lower than if you had invested the entire sum initially.
3. It works for a portfolio of stocks and not on a single stock or few number of stocks.  Remember SIP is to be used only for investment in portfolio of stocks such as mutual funds.  It cannot work on a single stock.  You cannot choose a stock such as say TCS and start investing a fixed sum every month in the same stock.  The reason being volatility of a single stock is far greater than that of a portfolio of stocks and the returns from your investment may be significantly different from that of the stock.
4. SIP works to your advantage only for diversified equity funds.  You should avoid SIP for sector-specific funds.  This is quite obvious.  SIP is for long term investing and sector-specific funds basically focuses on short term favourites.  A particular sector (for eg: health care sector) may be in demand currently, but will not be after say 5 years from now.  Hence SIP does not work in sector-specific funds.  Again the volatility of sector-specific fund is higher than volatility of diversified equity funds.

Advantages of SIP

Many.  Important of them are:

1. Long term focussed disciplined investing. 
2. It never tries to time the market.
3. It buys more in declining markets and less in rising markets. 
4. Advantageous for those who have regular stream of income to invest.

How to invest in SIP

As for any investment, it is first important to identify the goal you want to achieve through SIP investment.  Based on the goal and time horizon, you should decide the asset allocation and identify the monthly investment amount required to achieve the above goal.   Next thing is to select a good diversified equity mutual fund scheme.  This you can select either from Mint 50 listing of mutual funds or from sites like Valueresearch.  Keep monitoring the performance of the scheme.  In case it is consistently different from that of benchmark, you should consider exiting from it and selecting a new scheme.  And last but not the least, ensure long term commitment and keep investing periodically.  Happy investing. :)

Comments and suggestions welcome.

Investing through SIP

Post the volatile years of 2008 and 2009, financial advisors and mutual fund companies have started promoting Systematic Investment Plans (SIP) as a safest way to invest in equities.  No doubt SIP is one of the best ways to invest your funds, but you need to do your homework better to ensure that you make full use of its potential.

                        Also read: Your guide to mutual fund investments

What is SIP and how it works

SIP is an investment strategy in which one invests a fixed sum of amount periodically for a specific period.  In SIP, you mandate your fund house to invest a fixed sum on a fixed date for a fixed period.  The mandate can be given either through standing instructions or through post-dated cheques.  SIP can be started for an amount as low as Rs. 500 a month and there is no upper limit.  You need to choose the date on which you want to invest.  Generally the fund house gives you the option from which you can choose the date to invest. For example: HDFC Mutual Fund provides option to choose from 1^st, 5^th, 10^th, 15^th, 20^th or 25^th of every month.  Instead of monthly investment, there is an alternative for quarterly investment.  Further few mutual funds provide Daily Investment Plans (known as DIP) where one can invest daily instead of monthly.  The minimum period of investment can vary from 6 months to 12 months depending on the scheme you choose.  The period can be extended by providing additional post dated cheques or standing instructions.

How it creates wonders

The benefit from SIP is due to the fact that irrespective of what the market is, you keep investing fixed sum regularly.  This works to your benefits since at the time of rising market, you purchase less number of units of a fund; whereas in falling market you purchase more.  This is similar to an age old investment advice of buying when others are selling and selling when the others are buying.  Let us run an example to clarify this further.

Suppose you start a SIP of Rs. 5000 per month in Jan 2010.  You decide to invest on 5^th of every month for next twelve months. Let’s see how your sum gets invested.

  

The blue line is the movement in nifty index from January 2010 till date and the green bars are the number of mutual fund units purchased each month for SIP of Rs. 5000.  As can be seen from above graph, the largest number of units are purchased in the month of Feb 2010 when the index was lowest, whereas when index started rising from June 2010, the number of units keeps on reducing.  In other words, you are purchasing lesser number of units when the price rises and more number of units when the price falls.

This is one of the main advantages of SIP.  You keep on investing a fixed sum every month irrespective of the market movement and the cost averaging during high and low peak works in your favour.

In my next post, we shall discuss about the other advantages of SIP, times when the SIP does not works (yes, sometimes it is not beneficial to start an SIP) and what important things to consider before starting a SIP investment.  Nowadays advisors have started fooling investors in SIP. Hence you should not blindly start a SIP.  More on this in the next post.

Till then share your comments and suggestions on this article.  Thanks.

Rule of 72

Those who watched the final week’s episodes of Kaun Banega Crorepati will recollect there was a participant named Mahaveer Prasad (age 25 years) from a village in Rajasthan.  He won Rs. 6,40,000.  The unique thing about the participant was his approach to the money he will be winning from this contest.  Generally, the participants want to pursue their goals from the award money or to go for a world tour or to just save for future.  However, Mahaveer Prasad was much clear in his approach and stated that he will not expense out any money he wins.  He will save and try to double, triple or quadruple it.  When asked about how this can be achieved, he says that he will save it in bank deposits and after 8 years, the money will automatically be double!

Without going into whether this way is the most efficient way of doubling the money, we should appreciate his intention and clarity in investments.  At a young age of 25 years, he knows that he wants to save the money and want to grow it.  This he knows can be done through investment in instruments like fixed deposits and the money doubles after certain number of years.

 

The time period to double the money will vary depending on the type of instrument chosen for investment.  Further one need to consider the incidence of tax on the interest or profit generated.

The important point to note here is how simple is it to double one’s money within certain number of years.  Yet most of us just try to ignore investing since we do not know how our investment will look like after few years.  This uncertainty procrastinate the investment decision making.  It helps to visualize that by investing in a particular company’s bond, my money will double in 9 years.  This way we know the time frame as well as the final value of the investment.

The Rule of 72 helps us in visualizing how our investment will be after a certain time period.  This is a simple rule which tells how long will it take to double your money if you have it invested at a certain interest rate.  You just need to divide 72 by the rate of interest offered on the instrument.  The answer is the number of years it takes to double your money.  For eg:  If you earn an interest of 8% on a fixed deposit, your money will be double if you stay invested for 72 divided by 8 i.e. 9 years.

This assumes you keep on reinvesting the annual interest earned at the same rate and ignores the tax aspect on income.

This rule can be handful in comparing various investment products.  In case your goal is to double or quadruple your money to buy a car or your dream home, you can calculate the number of years it will take by this formula.

The table below shows the number of years it takes to double the money at various rates.

Rate of Return	No. of Years
5%	14.40
6%	12.00
7%	10.29
8%	9.00
9%	8.00
10%	7.20
11%	6.55
12%	6.00

Where you aware about the rule of 72?  Whether visualizing your money after the investment horizon helps you in making investment decision? Do share your comments and suggestions below.

PPF - Are you aware about its unique features?

Public Provident Fund (PPF) is an ideal vehicle for long term investment in debt category.  It is an important retirement saving tool for individuals, more so for those who are not salaried employees.  For salaried individuals, certain percentage of their salary, which is match by his / her employer, mandatorily gets invested in Employee Provident Fund.  However, for other individuals such as businessmen, there is no such mandatory deduction from income.  Hence it is important to have PPF as one of the investment vehicle for retirement savings.

                

Also read: EPF or PPF – Which one is better to invest?

 

Basic features of PPF:

PPF scheme is governed by The Public Provident Fund Act, 1968 and the scheme formulated thereunder.  Any individual can open a PPF account for himself or on behalf of minor.  NRIs are not eligible to open a PPF account.

One need to invest a minimum of Rs. 500 and can invest up to a maximum of Rs. 70,000 per annum in a PPF account. Maximum limit of Rs. 70,000 also takes into consideration investment in minor’s account.  Interest is calculated on the lowest balance between the close of the fifth day and the end of the month and shall be credited to the account at the end of each year at the rate notified by the Government.  Since March 2003, interest is paid @ 8% p.a.  The tenure of the investment is 15 years; however the actual term is slightly higher (more on this below).  The contribution to PPF is allowed as deduction under Section 80C of the Income Tax Act.  Further, the maturity proceed along with interest is entirely tax free.

Tip: Since Section 80C allows you to claim deduction for your spouse as well as children, one can claim entire benefit of Section 80C up to Rs. 1,00,000 just by investing in PPF account, dividing the contribution between self, spouse and children.

Other important aspect of PPF investments:

While above are the basic features of PPF investment which everyone knows, one should also be aware about other important aspects.  For eg:  Are you aware that your PPF investment is protected against attachment under any decree or order of any court in respect of any debt or liability?  This means that in case of any liability, the creditor or bank cannot recover the said amount from your PPF account.  Further do you know that the actual tenure of PPF is more than 15 years?  It can be anywhere from 16 years 1 day to 17 years depending on the date of opening the account.  Let’s discuss such features in detail.

1.   PPF funds are protected against attachment under any decree or order of any court in respect of any debt or liability.

2.   One can make investment for maximum 12 times in a year.

3.   In case, one fails to contribute minimum amount of Rs. 500 for a year or for few years, such default can be condoned by paying Rs. 50 per year of default along with contribution of Rs. 500 for each such defaulting year.

4.   Partial withdrawal is permissible after five years from the end of the year initial investment was carried out.  Such withdrawal is restricted to lowest of 50% of the following amount:

                 i.  Balance outstanding at the end of the forth year immediately preceding the year of withdrawal or

                ii.  Balance outstanding at the end of preceding year.

For example:  Let’s assume Year 1 is the year you opened the PPF account.  You will be able to make partial withdrawal from Year 7 (i.e. after 5 years from the end of the year initial investment was carried out).  The maximum amount permissible will be calculated as lower of 50% of:

                           i.  Balance outstanding at the end of Year 3 or

                          ii.  Balance outstanding at the end of Year 6.

However, only one withdrawal is allowed in a year.

5.   PPF account can be close after the end of 15 years from the end of the year initial subscription was made.  Hence the term of the PPF account can be anywhere from 16 years 1 day to 17 years.  There is also an option to withdraw over a period of time. However, only 1 withdrawal can be made in a year.

Tip: It is advisable to open the account in the month of March, rather than in April.  This way your term will be restricted to just little more than 16 years.

6.   After the end of 15 years, it is possible to continue the PPF account.  It can be done by submitting the prescribe form along with the contribution for that year before the end of 16^th year.  This continuation is for further block period of 5 years which can be further extended for another 5 years and so on.  Withdrawals are possible provided that the total of all withdrawals shall not exceed 60% of the outstanding balance at the commencement of the said block period. 

For example:  Assume at the end of 15 years, you have Rs. 30,00,000 in your PPF account.  In case you have opted for continuation for another block of 5 years, you can withdraw maximum of Rs. 18,00,000 (60% of Rs. 30,00,000) during the said 5 years.

7.   One can avail loans on PPF investment.  Technically loans can be availed from 3^rd year but before the expiry of five years.  Loan amount is capped at 25% of the balance outstanding at the end of second year immediately preceding the year in which loan is applied for.

For example:  In case you wish to apply for loan in the Year 4, maximum  you can apply for will be restricted to 25% of the amount outstanding at the end of Year 2. 

Such loan has to be repaid within 36 months.  This period is calculated from next calendar month.  Repayment can either be lumpsum or by two or more installments.  After principal repayment, interest has to be paid @ 1% in not more than two monthly installments.  Thus the effective rate of interest is PPF rate + 1%.  Interest is calculated for the period commencing from first day of month following the month in which loan is drawn till the last day of the month in which the last installment is paid. 

Tip: Since the interest amount is fixed irrespective of the quantum and timing of principal repayment over the period of 36 months, it is advisable to pay the entire principal during the later period of 36 months. (Please correct me if I am wrong)

In case, loan is not repaid in full within above prescribed 36 months, interest rate on outstanding balance is charged @ 6% commencing from first day of month following the month in which loan was taken up to the last day of the month in which the last installment is paid.

8.   One can make nomination for receipt of PPF balance in the event of the death of subscriber.  However, trust cannot be a nominee.  In case no nomination is carried out, then the legal heirs have to submit application for withdrawal of funds in Form G along with necessary supporting to prove their ownership.  In such cases, the legal heir can withdraw upto Rs. 1 lakhs without any ownership proof, provided they sign the prescribed indemnity letter.  For any amount above Rs. 1 lakhs, they need to submit the ownership proof.

Following are the links to various forms required for PPF Investments:

Form A	PPF Account Opening Form
Form B	PPF Deposit Form
Form C	Withdrawal of funds / Closure of account after 15 years
Form D	Loan Application
Form E	Nomination Form
Form F	Change in Nomination Form
Form G	Application for withdrawal by Nominees / Legal Heir
Form H	Continuation of accounts for another 5 years

Whether the above post on PPF useful?  Where you aware of the unique provisions in PPF?  Are you aware of any more tax planning tools in relation to PPF?  Do share them below along with your comments.