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A Guide to Understanding SIP Return Calculation
A Systematic Investment Plan (SIP) lets you invest a fixed sum of money regularly in a mutual fund scheme for a predetermined tenure. Advantages of SIP include potential for higher returns through compounding and lower overall cost of investment. As an investor, it is crucial to know how to calculate SIP returns to truly ascertain if your selected mutual fund scheme is working for you or not. In this article, we’re going to take a look at three different ways through which you can calculate the returns from a SIP and the importance of each of these methods.
How to calculate SIP investment returns?
The three important methods that most investors use to calculate the returns from a Systematic Investment Plan are - absolute returns, Compound Annual Growth Rate (CAGR) and Extended Internal Rate of Return (XIRR). Here’s a detailed overview of each of these methods and how they work.
Most guides on how SIP returns are calculated feature this method since it is one of the most straightforward ways to arrive at the returns from your investment. Absolute returns indicate the returns your investment has generated on a particular date. The formula that’s used to calculate absolute returns is as follows.
Here’s a hypothetical example of how to calculate the SIP returns using the absolute returns method.
Assume you invested in a mutual fund SIP. The fund’s average NAV is Rs. 180. Currently, the fund’s NAV is Rs. 240. When you apply these metrics in the above-mentioned formula, you will get the absolute returns.
Going by the absolute returns method, your mutual fund SIP has generated 33.33% returns.
Benefits and Drawbacks of Absolute Returns
One of the advantages of this SIP return calculation method is the relative ease with which you can ascertain your SIP returns. However, this method also has a major drawback. For instance, it doesn’t provide any context to the generated returns since it doesn’t take the tenure or the timing of your investments into account. Now, in the above example, 33.33% returns may seem to be nothing short of exceptional, but it doesn’t tell you whether these returns were achieved in 3 months, 1 year or 5 years.
Compound Annual Growth Rate (CAGR)
Many investors often use the Compound Annual Growth Rate (CAGR) to determine the returns from a mutual fund. Unlike absolute returns, the CAGR takes the tenure of your investment into account. It gives you an average of the returns your investment has generated over a certain period. As the name implies, the method also takes into account the compounding factor.
The mathematical formula used to calculate the Compound Annual Growth Rate (CAGR) is as follows.
Here, the final investment refers to the amount you receive when you sell off all your mutual fund holdings. Average investment, meanwhile, refers to the average amount of investment in the fund and is calculated by multiplying the number of units you own with the average NAV. Finally, ‘n’ refers to the total tenure.
Let’s learn how to calculate CAGR for a SIP in a mutual fund with the help of a hypothetical example.
Assume that the average NAV is Rs. 100 and you own 1,000 mutual fund units. The average investment, in this case, would be Rs. 1,00,000 (Rs. 100 x 1,000 units). The final investment value is Rs. 1,60,000 (Rs. 160 x 1,000 units). The tenure of the investment is 4 years. Substituting these values in the above-mentioned mathematical formula should give you the Compound Annual Growth Rate of your mutual fund SIP investment.
According to this method, the Compound Annual Growth Rate of your mutual fund SIP investment is 9.9% per annum. This effectively means that your mutual fund investment grew at an average rate of 9.9% every year for 5 years.
Benefits and Drawbacks of CAGR
Compared to absolute returns, CAGR gives you a better context of how your investment has grown over the years. That said, although the Compound Annual Growth Rate takes the tenure into consideration, it doesn’t take the timing of your investments into account, which is very important for a SIP. This makes this method more suitable for lump sum investments rather than a Systematic Investment Plan. Furthermore, since this method disregards market volatility, using this method to determine how SIP is calculated may not be advisable.
Extended Internal Rate of Return (XIRR)
Out of the three methods used to calculate mutual fund returns, the Extended Internal Rate of Return (XIRR) is the most accurate. It is designed for Systematic Investment Plans where you make investments in a fund regularly over a long period of time.
The XIRR is a unique function available in spreadsheet software like Microsoft Excel. The function works by determining the Compound Annual Growth Rate (CAGR) of every SIP installment, from the date of investment up until the current date. Once the CAGRs of all the investments are determined, the XIRR function aggregates them to provide the rate of mutual fund SIP return.
The formula for Extended Internal Rate of Return that you need to use in a spreadsheet software like Microsoft Excel is as follows.
Here, cash flows represent the amount of investment you make in each instalment, whereas dates represent the date at which each instalment is made.
Let’s take up a hypothetical example to properly understand how this spreadsheet formula works.
Assume you start a SIP by investing Rs. 1,000 per month on the 1st of January 2020. You choose to continue investing the same amount until the 1st of December, 2022. In this case, the XIRR formula you would have to enter into the spreadsheet software would look like this.
As soon as you enter all of the information in the formula, the spreadsheet software will instantly show you the annualised return of your mutual fund investment. So, if the XIRR is 8.65%, it effectively means that the average annual return on your SIP investment is 8.65%.
Benefits and Drawbacks of Extended Internal Rate of Return
Compared to the other two methods, the Extended Internal Rate of Return is the most accurate at determining a mutual fund SIP’s return. It takes into account the tenure of your investment as well as the timing, which are key factors that play a huge role in the calculation of average returns. That said, a drawback with the XIRR is that you require access to a spreadsheet program like Microsoft Excel or a dedicated financial calculator. This limits access and can make it hard for individuals who don’t have access to either tool to calculate the XIRR. But don’t worry, you can use our SIP calculator to quickly calculate your SIP returns.
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