What is a Systematic Investment Plan - SIP
A systematic investment plan (SIP) is a plan where investors make regular, equal payments into a mutual fund, trading account or retirement account, such as a 401(k), and benefit from the long-term advantages of dollar-cost averaging (DCA) and the convenience of saving regularly without taking any actions except the initial setup of the SIP. Because dollar-cost averaging involves buying a fixed-dollar amount of a security regardless of its price, shares are bought at various prices, the average cost per share of the security decreases over time and the risk of investing a large amount of money into a security lessens.
BREAKING DOWN Systematic Investment Plan - SIP
A money market account or other liquid account is typically used for funding payments or buying shares going into a systematic investment plan. In addition to SIPs, many investors reinvest dividends received from their holdings back into purchasing more stock, called dividend reinvestment plans (DRIPs).
SIP and Dollar-Cost Averaging
Systematic investing is the basis of dollar-cost averaging, an investment strategy implementing the regular and periodic purchasing of investment shares. Dollar-cost averaging reduces the overall cost per share of an investment.
Most DCA strategies are established with an automatic purchasing schedule. Because greed, fear, complacency and other negative feelings may affect investment selection and asset allocation, DCA removes the investor’s potential for making poor decisions based on emotional reactions to market fluctuations. For example, when stock prices soar and news sources report new records on stock indices and potential profit, investors typically buy more risky assets such as stock and stock mutual funds. In contrast, when stock prices drop dramatically for an extended period of time, many investors sell their shares. Buying high and selling low is in direct contrast with dollar-cost averaging and other wise investment practices, especially for long-term investors.
SIP and Dividend Reinvestment Plans
Dividend reinvestment plans let shareholders invest variable amounts in a company over a long-term investment. Reinvesting dividends means shareholders may purchase shares or fractions of shares in publicly traded companies. Rather than sending the investor a quarterly check for dividends, the company, transfer agent or brokerage firm uses the money for purchasing additional shares of the company in the investor’s name.
Because there is no broker required for facilitating the trade, company-operated DRIPs are commission-free. Some DRIPs offer optional cash purchases of additional shares directly from the company at a 1 to 10% discount with no fees. Because DRIPs are flexible, investors may invest large or small amounts of money, depending on their financial situation.
Drawbacks of Systematic Investment Plans
Although they can help an investor maintain steady purchases, systematic investment plans have several stipulations. For example, they often require a long-term commitment, anywhere from 15 to 25 years. Quitting the plan before the end date, while allowed, can incur a hefty sales charges, sometimes up to half of the investment. Systematic investment plans can also be costly. A "creation and sales charge" can run up to half of the first 12 months' investments. In addition, investors should look out for mutual fund fees and custodial and service fees if applicable.