When considering the growth trajectory of a systematic investment plan (SIP) in mutual funds, a critical measure often used is the Compounded Annual Growth Rate (CAGR). This financial metric is key to understanding the mean annual growth rate of an investment over a specified time frame longer than one year. It presents a smoothed annual rate of growth, negating the fluctuations that occur during the investment period. Here’s an insight into the computation and significance of CAGR in the context of SIPs.
What Is Compounding?
Compounding is the process where the value of an investment grows due to the earnings on both the original investment and the accumulated earnings from preceding periods.
Consider an initial investment of ₹100 with a 5% compound interest rate. In the initial year, the investment accrues ₹5, raising the total value to ₹105. The following year, the interest is calculated on the new total, leading to an interest amount of ₹5.25. This process demonstrates the concept of earning ‘interest on interest’, which applies to mutual funds as the profits can be reinvested to earn additional returns.
The compounding effect increases with the length of the investment period, significantly enhancing the potential for wealth generation. For instance, a mutual fund investment of ₹1 lakh with a 10% compounded return annually would grow to approximately ₹6.7 lakh over two decades. This illustrates the power of compounding, where the original investment has expanded by nearly sevenfold.
What is CAGR?
CAGR stands for Compound Annual Growth Rate. It is a measure of the mean annual growth rate of an investment over a specified period longer than one year. It represents one of the most accurate ways to calculate and determine returns for anything that can rise or fall in value over time. Investors use CAGR to evaluate the performance of different investments or to compare the historical returns of a single investment against other investments or savings accounts.
Calculation of CAGR
CAGR for SIP investments is computed using a formula that takes into account the total value of the investment at the end, the total amount of money invested, and the time duration of the investment. The formula for CAGR is:
CAGR = (Ending Value / Beginning Value)^(1 / Number of Years) – 1
For SIPs, the calculation of CAGR is more nuanced because different tranches of investment grow for different periods. This is where the use of a SIP CAGR calculator, which incorporates variables such as the frequency of investments and the rate of return on each instalment, becomes vital.
An Example of CAGR Calculation for SIP
Let’s assume you’ve been investing ₹10,000 per month in an SIP for three years. The total investment made is ₹3,60,000. At the end of three years, the value of the investment is ₹5,00,000. To calculate the CAGR:
Identify the total investment (BV) which is ₹3,60,000.
Determine the ending value (EV), which is ₹5,00,000.
Establish the number of years (n), which is 3.
Inserting these into the formula gives us the CAGR.
CAGR = (3,60,000 / 5,00,000)^(1 /3) – 1
CAGR = (0.72)^(1 /3) – 1
CAGR = 11.57%
However, due to the nature of SIPs, calculating CAGR directly using this formula would not yield an accurate result since it doesn’t account for the fact that each SIP instalment has not been invested for the full three years.
For a precise computation, the use of an XIRR function in a spreadsheet is recommended. XIRR provides an exact CAGR for cash flows occurring at irregular intervals, which is characteristic of SIPs.
Relevance of CAGR in SIPs
Investors prefer SIPs for their disciplined approach to investing, enabling participation in the market irrespective of its volatile nature. CAGR steps in as a tool to provide a realistic growth estimate, smoothing out volatility by providing a geometric average return. This is especially beneficial in the evaluation of an SIP’s performance, where periodic investments are made, often resulting in various amounts of money being invested for different periods.
Conclusion
CAGR is a handy gauge to understand your SIP’s growth over time. It simplifies the growth rate to an average yearly figure, helping you compare and track your investments efficiently.
However, remember it’s just one tool and doesn’t show the whole picture. To get a precise CAGR for your SIP, use an online CAGR calculator. It’s quick, easy, and can give you a clearer view of your investment’s performance. Go ahead and try out the Angel One CAGR calculator to calculate the CAGR required for the future value of your investments!
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