How are Returns Calculated in SIP?

“If you can’t measure it, you can’t improve it,” goes a popular saying. It is impossible to overstate the value of measurement, particularly in investing, where returns show how well your financial efforts are working out.

Investing in mutual funds through a systematic investment plan (SIP) has recently gained popularity. SIP allows an investor to invest a predetermined amount of money periodically, making it a disciplined and convenient approach to wealth creation.

Calculating returns, however, can be challenging because of the nature of SIP and the fluctuating net asset value (NAV) of mutual fund units. This article will go over how returns are calculated for SIP and the various methods used to do so.

The SIP calculator can simplify these calculations, helping investors make informed decisions when investing in mutual fund schemes.

1. Absolute Return

Absolute return helps an investor measure the returns of an investment by considering the initial and present value of the investment. The absolute return calculation approach is simple and appropriate for gauging an investment’s short-term success.

Absolute returns can be calculated using the following formula:

Absolute return = [(Final value – Initial value) / Initial value] * 100

Here’s an example of how absolute returns are calculated.

Mr. A invested ₹1,00,000 in a mutual fund. After a while, the investment had grown to ₹2,00,000.

Using the above formula, the absolute returns of the investment can be measured:

Absolute Return = [(2,00,000 – 1,00,000)/1,00,000] * 100

= 100%

Therefore, the absolute return on Mr. A’s investment is 100%.

Although calculating absolute returns is straightforward and requires less information, it has several drawbacks. As the method does not consider the tenure of the investment, it fails to measure the pace at which the investment grew or declined.

For instance, Mr. A’s investment yielded returns of 100%. However, absolute returns do not indicate whether the growth happened over a couple of months, a year, or multiple years.

Further, absolute returns are unreliable when comparing different mutual funds. Let’s say one investment delivered an absolute return of 500% over 10 years while another investment delivered an absolute return of 300% in 7 years. Since the holding period for both investments varies, it is difficult to gauge which of the investments performed better.

2. Compounded Annual Growth Rate (CAGR)

Another technique for figuring your SIP returns is the compound annual growth rate (CAGR), which gauges the investment’s yearly growth. CAGR takes the investment tenure into account, which reduces the limitations of the absolute returns method of calculation.

CAGR also considers compounding a crucial factor in SIP returns. Compounding refers to reinvesting profits, which results in exponential growth over a longer period.

CAGR is calculated using the following formula:

CAGR = [(Final investment value / Initial investment value)^(1/n)] – 1

Where n = the investment tenure in years.

For instance, if an investor starts SIP and the investment grows from ₹1,00,000 to ₹2,50,000 in 5 years, the CAGR can be calculated as follows:

CAGR = [(2,50,000 / 1,00,000)^(1/5)] – 1

Using the SIP calculator, investors can determine the CAGR more conveniently, ensuring accuracy while analysing potential returns when they invest in mutual fund schemes.

3. XIRR (Extended Internal Rate of Return)

Unlike lump sum investments, SIP involves investing at different time intervals, making the calculation of returns more complex. XIRR is a method specifically designed to measure SIP returns more accurately.

XIRR is useful because it considers the multiple cash flows involved in SIP, allowing investors to determine the true rate of return. This method is especially important because, in an SIP, each investment instalment is made at a different NAV.

The formula for XIRR is complex and requires financial software or a SIP calculator to compute accurately. However, its application provides a more precise picture of SIP returns compared to absolute return or CAGR.

Which Method Should You Use?

The best method to calculate SIP returns depends on the investment scenario:

1. Use Absolute Return for a quick, straightforward measurement of gains over a short period.
2. Use CAGR when assessing a single investment over multiple years to understand annualised growth.
3. Use XIRR for accurate SIP return calculations, as it considers multiple investment entries over time.

Conclusion

Measuring investment returns is crucial to making informed financial decisions. Whether you use absolute return, CAGR, or XIRR, understanding how returns are calculated helps you assess the effectiveness of your SIP strategy.

SIP calculator can simplify these calculations, helping investors make better choices when investing in mutual fund schemes. Investors can optimise their investment approach by regularly evaluating performance, ensuring steady financial growth over time.