The maths is simple. You invest a fixed amount every month in a mutual fund. Automatically, this implements the holy grail of investing--buy low, sell high. Here's how.
Since SIPs mean investing with a fixed sum regularly regardless of the NAV or market level, you end up getting more units when the markets are low. It's simple to understand. Let's say you are investing Rs 20,000 every month. When the NAV is Rs 20, you will get 1000 units, because 20000/20 = 1000. However, if the market dips and the NAV drops to Rs 16, you will get allotted 1350 units, as 10000/16 = 625. This is the key. You have automatically bought more units when the markets are lower. Thus, SIP means investing a fixed sum regularly, generally at a frequency of once a month. Since the investment happens regardless of the NAV or market level, investors automatically buy more units when the markets are low. This results in a lower average price, which translates to higher returns.
When you want to redeem your investment in the mutual fund, all the units you own are worth the same. However, your profit margin is higher for units that were bought at a lower price. Effectively, you have paid a lower average price, which translates to higher returns. That automatically enforces the investor's goal of 'Buy Low, Sell High'.
So, what's this bit about the psychology? The biggest problem in investing is not in where to invest. Instead, it is whether to invest at all and keep investing through thick and thin. People invest sporadically and then stop investing when equity markets fall. This comes naturally to most investors, generally because falling equity prices are presented as a crisis in the mass media. Of course, this makes no sense. As a buyer of anything, you want low prices. So should you as a buyer of equity or equity mutual funds. But for the most part, investors do not.
SIPs neatly solve these two problems that prevent investors from getting the best possible returns for their money. They are actually the best feature in mutual fund investing and yet are not actual funds themselves. SIPs are the schedule on which you invest.
However, while this maths is great, it's not the main reason why people get great returns out of SIP investing. The reason for the returns is in the psychology of investing. SIPs are the simplest way of investing regularly and getting good returns from equity, without having to worry about when to invest and when not to invest and thus often missing out on the best opportunities. When the markets turn discouraging, the general instinct of many investors is to stop investing, either because they are scared or because they are trying to catch the bottom. However, SIP investors - not all but most - tend to continue their SIPs. Soon, when the markets go up, this teaches them the value of not stopping their SIPs in bad markets. Thus begins a virtuous cycle, creating a larger new generation of investors who understand the value of regular investing.
Over the last three to five years, an additional development in the actual mode of paying for the SIP investment has improved matters further. Earlier, SIPs meant writing a pile of cheques and giving them to the fund. Obviously, there was a limit to this, generally anything from 12 to 36 months. As a result, investors felt that an SIP was a fixed tenure plan. When the cheques would run out, investors would take their time to go through the whole effort again. At that point, if the markets were looking depressed, they would not do it at all.
Now, investors generally give an ECS mandate for the monthly SIP investment amount to be directly transferred from their bank accounts. Generally, this is a perpetual mandate. Stopping the SIP requires an instruction to be registered. Earlier, stopping was automatic but continuing involved a fresh pile of cheques to be written. In my experience with investors, I have felt that this change of defaults has had a huge impact.
The kind of returns that one can get with SIPs are truly mind-boggling. Here are a few very long-term examples. I took up four funds that have been around for decades. Then, using the free Portfolio Manager on Value Research Online, I calculated what would have happened if I had done a modest SIP for the last twenty years.
It turns out that just a small investment of Rs 5,000 a month over two decades left me with sums of Rs 1.29 crore, Rs 1.85 crore, Rs 1.21 crore, and Rs 2.05 crore for the four funds. The amount invested in each case was just Rs 12 lakh (Rs 5000 a month for 20 years). An investment like this can change the life of a middle-class person? However, there's no special complexity in doing this. Just something straightforward, done over a long period.