These days, a popular and easy way to invest small amounts regularly in mutual funds is through a systematic investment plan (SIP). SIP helps people build capital over time with discipline. However, calculating the returns from SIPs is not as simple as with one-time investments because the capital gets invested at different times. To understand how your SIP is performing, you need to know the correct way to calculate its returns. This article will help you understand how SIP returns are calculated and why using the correct method is important for your growth.
Understanding the SIP Return Calculation
In lump sum investments, you invest a single amount once and calculate returns on that same amount, but in SIP, there are multiple investments at regular intervals. Depending on the market condition, each instalment buys units of the mutual fund at a different net asset value (NAV). This means returns must be calculated based on both the amount and timing of each investment to show accurate performance. To make this process easy, investors use a SIP calculator that simply factors in variables to help you accurately estimate your SIP returns.
Methods to Calculate SIP Returns
There are three ways to calculate the returns on investment. Let’s take a detailed look.
Compound Annual Growth
Compound annual growth (CAGR) helps you to calculate the average yearly growth of an investment over a set period. Instead of manually calculating the annual returns, a CAGR calculator makes the process easy and gives accurate results. This is especially useful for long-term investments, as it shows how your capital has grown over time while ignoring short-term market ups and downs.
The formula for CAGR is: CAGR = (FV / PV) ^ (1 / n) – 1
Where:
- PV represents here the beginning value, which is the starting value of the investment.
- FV represents the ending value of the investment at the end of the period.
- N represents the number of years of the investment period.
For example, suppose you invested ₹10,000 in a mutual fund, and after 5 years, the investment grew to ₹16,105.
- PV (Beginning Value) = ₹10,000
- FV (Ending Value) = ₹16,105
- n (Number of years) = 5
Using the CAGR formula, the investment grew at an average rate of 10% per year over 5 years.
Absolute Return
Absolute return is an easy way for investors to calculate how their investment is performing by simply comparing the initial amount invested with the current value. This method is easy to calculate and is often used to evaluate short-term investment performance.
The formula for absolute return is: Absolute Return = ((Final Value – Initial Value) / Initial Value) × 100
For example, suppose Mr. A invested Rs 80,000 in a mutual fund, and after some time, the investment value increased to Rs 96,000.
By applying the formula:
Absolute Return = ((96,000 – 80,000) / 80,000) × 100 = (16,000 / 80,000) × 100 = 20%
So, Mr. A has earned a 20% absolute return on his investment.
The absolute return calculation is simple, and it requires minimal data. In this calculation, the duration of the investment is not considered. This means it can’t tell you how quickly the investment grew. For instance, Mr A’s 20% return doesn’t reveal whether it took 3 months, 1 year, or several years to achieve this growth.
Furthermore, absolute returns can be misleading when compared to different investments. Imagine one fund gives a 150% return over 10 years, and another delivers a 120% return over 5 years. Since the time frames are different, absolute returns alone don’t show which fund performed better on an annual basis.
XIRR (Extended Internal Rate of Return)
XIRR is a short method for calculating SIP returns. It accounts for each investment date and amount, along with the final investment value. This method calculates the annualised return on your capital by considering the exact cash flow timings, making it suitable for SIPs with multiple investments over time.
Many online tools and mutual fund platforms provide XIRR calculations to help investors understand their SIP performance better.
To manually calculate SIP returns using XIRR:
- You need to record each SIP instalment as a negative cash flow on the respective investment dates.
- Enter the current market value of your SIP holdings as a positive cash flow on the date of calculation.
- Use the XIRR function in Excel or a financial calculator to find the annualised return.
Why Choosing the Right Calculation Method Matters
Choosing the right calculator method is important as it helps you with:
- Comparing your returns against benchmarks or other investment options.
- Track progress toward your financial goals realistically.
- Make informed decisions about whether to continue, increase, or modify your SIP investments.
To achieve this, you may use a reliable SIP calculator app, as it applies the correct method and provides a clear picture of your investment’s performance.
Conclusion
Calculating returns on SIP investments is considered complex than on lump sum investments due to multiple investments made at different times. While absolute returns and CAGR offer some insight, they fall short in accurately reflecting the true performance of SIPs. The XIRR method stands out as a precise way to calculate SIP returns because it considers each investment’s timing and amount. Using the correct calculation method is crucial for making informed investment decisions and tracking your progress effectively.
