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Turning a stream of income

An equity SIP can perform the miraculous feat of transforming a bit of your monthly income into capital deployed in a business

Turning income into capital

Two weeks ago, I discussed the maths and the psychology of Systematic Investment Plans (SIPs) in these pages. We saw that the logic of SIPs is impeccable and there is no better way to invest in mutual funds. However, there's actually more to it than just that--a lot more.

Last month, I came across this statement by John Bogle, "[Without the equity markets,] there would be no way to turn a stream of income into a pile of capital or a pile of capital into a stream of income." Bogle is, for all practical purposes, the inventor of the index investing as a practical product. There are few people who have done as much as Bogle to make the idea of steady, low-cost long-term investing a success. So what does he mean by the above statement? How do the equity markets 'turn a stream of income into a pile of capital' for an ordinary investor? And what does this have to do with SIPs?

Firstly, we have to appreciate that equity and equity mutual funds are a unique type of investment when compared to the various kinds of deposits that Indian savers are so fond of. As I'd written in one of the early articles in this series, when we invest in equity, we become part owner of a company. Boiled down to the basics, there are only two ways of investing money--either you can lend it to someone, or you can own your own business. While founding and running an entire business is not everyone's cup of tea, the existence of the stock markets means that any of us can be part-owners of a business. We can get a share in the profit stream of a business without the hassle of running a business.

As Bogle points out, essentially, your income stream has become part of a pool of capital that is funding a business. Instead of being entitled to just a fixed income on the money, you can--depending on how well you invest--become entitled to profits. Not just that, since the capital markets price stocks on what they believe the future holds, your investments gain in value based on that too.

So where do SIPs fit in? Simply by aligning with the pattern of income that most savers have, and by making this conversion of your income into capital effortless and automatic. Most of us earn and spend our income on a monthly cycle. Having a little bit of this flow systematically into an SIP becomes an easy way of linking your income to something that turns it into capital deployed in a business. This is something that is a relatively new phenomena in saving and investing.

No one in an earlier generation was able to do this. Open-ended mutual funds, electronic transfer of funds from banks, online confirmations and monitoring are some of the tools that have made this possible.

A long-term SIP is the nearest thing to a certainty that exists in investing. When you look at it with the perspective I've presented above, that of a steady income transforming into capital, it becomes obvious that this should be the centrepiece of your lifetime investment plans. Some time ago, we did an extensive study at Value Research on how long must one run an SIP for the chances of a loss to be minimised.

While you can find the details in Mutual Fund Insight magazine, the main finding was that an SIP investment period of a mere three years meant that the investments had positive returns in more than 90 per cent of the cases. At four years, this was up to 94 per cent. Even for a two year investment, which is too short in every way, positive returns are found in 84 per cent of cases. If this is the kind of a deal that equity SIPs offer, it's foolhardy not to invest.