Investing in the stock market can be an effective way to grow one’s wealth over time. However, most new investors struggle to decide whether to invest a lump sum amount upfront or use the Systematic Investment Plan (SIP) approach for regular investments. The key difference lies in the compound annual growth rate (CAGR) generated from both methods.
This blog post will help readers understand what CAGR means, how it is calculated, and how it can differ significantly between lump sum and SIP investments in stocks.
What is CAGR, and How is it Calculated?
CAGR, or Compound Annual Growth Rate, indicates the annual return on investment over a period of time. It factors in the effect of compounding, which allows the invested money to earn returns on top of returns. One can use a CAGR calculator online to calculate the returns on their investments. Here is the formula commonly used in a CAGR calculator:
CAGR = (End Value of Investment/Starting Value of Investment)^(1/No. of years of Investment) – 1
Let us understand the calculation of CAGR with the help of an example:
Initial investment (Starting Value): ₹1,00,000
Value after 5 years (Ending Value): ₹1,61,051
Number of years: 5
Plugging these values into the formula, we have:
CAGR = (1,61,051/1,00,000)^(1/5) – 1 = 12%
So if ₹1 lakh investment grows to ₹1.61 lakhs in 5 years, the annual return or CAGR is 12%.
Understanding CAGR: Lumpsum Investment v/s SIPs
Let us now see how CAGR differs in terms of lumpsum and SIP investments:
Lumpsum Investments
In lumpsum investing, one puts a large one-time amount into stocks or funds. For example, investing ₹5 lakhs in equity funds at one go qualifies as a lumpsum investment.
The key thing to note here is that one starts earning returns on the entire capital from day one. The entire investment amount of ₹5 lakhs is fully invested right from the beginning, giving a higher potential for compounding.
For example:
Lumpsum Investment on 1 Jan 2020: ₹5,00,000
Value as of 1 Jan 2025 (after 5 years): ₹9,14,035
CAGR = (9,14,035/5,00,000)^(1/5) – 1 = 16.09%
So through the power of compounding, a lumpsum investment of ₹5 lakhs grew to over ₹9 lakhs in 5 years, giving the investor a CAGR of 16.09%
SIP Investments
A Systematic Investment Plan (SIP) involves regularly investing a fixed amount in stocks or funds every month. For example, one can invest ₹10,000 every month with a monthly SIP. Here, the entire capital does not start earning returns from day one. As one keeps investing every month, the amount that goes into the market as an investment keeps growing.
For example:
Monthly SIP Amount: ₹10,000
SIP Tenure: 5 Years (60 months)
Total Invested: ₹6,00,000 (₹10,000 x 60 months)
Value after 5 Years: ₹8,92,800
CAGR = (8,92,800/6,00,000)^(1/5) – 1 = 13.44%
Through SIP, a total investment of ₹6 lakhs over 5 years grew to ₹8.92 lakhs, giving a CAGR of 13.44%.
The CAGR is lower than lumpsum investing as the entire capital does not earn returns from the start.
Why is CAGR From Lumpsum Investing Higher?
In the above examples, we saw that the CAGR from lumpsum investing was 16.09%, while the CAGR from SIP was 13.44%. The key reason for this difference between the two rates of returns is the early start to compounding and higher time spent in the market in the case of lumpsum investments.
In lumpsum investing, the entire principal amount begins earning returns from day one. Over the investment’s tenure, this can magnify into significantly higher gains. On the other hand, in SIP investments, one can delay investing a portion of their intended amount for the future. So, the full power of compounding does not apply to the entire amount.
To explain this further, here is a break-up of how much is invested through SIP every year for 5 years:
Year 1: ₹1,20,000 (₹10,000/month)
Year 2: ₹2,40,000 (₹10,000/month)
Year 3: ₹3,60,000 (₹10,000/month)
Year 4: ₹4,80,000 (₹10,000/month)
Year 5: ₹6,00,000 (₹10,000/month)
As one can see, the amount grows year-on-year, and only by the fifth year does the investment amount match the value of the initial lump sum investment. In lumpsum investing, on the other hand, the entire ₹6 lakhs would have been invested in the very first year itself, earning higher returns through early compounding.
Hence, the CAGR of lumpsum investments tends to be higher than that of SIPs, given the same total investment amount and tenure. In addition to CAGR, one can also calculate other financial metrics online using calculators like interest rate calculators, loan calculators, and gratuity calculators. A gratuity calculator can help one calculate the retirement gratuity amount accurately.
Which is Better: Lumpsum Investing vs SIPs?
After understanding the CAGR difference between both investment approaches, this section can help investors decide on the better mode of investing. Here are a few key pointers to help investors decide:
- If an investor has a large amount to invest upfront, lumpsum investing can help benefit from full compounding. One can put in, say, ₹5-10 lakhs into equity funds in one go to earn better returns from compounding.
- Most retail investors have a surplus monthly income rather than a considerable corpus. For them, SIPs allow disciplined investing every month.
- Instead of waiting to accumulate a large lumpsum, start a SIP early with whatever amount you can spare every month, say ₹5,000-10,000.
- SIPs can help investors average out stock market volatility. They allow investors to buy more units when prices are low and less when prices are high.
- Even if one has a lumpsum, an investor can stagger it into smaller SIPs to take advantage of market corrections.
- So, both SIPs and lumpsum investing have pros and cons for investors. Investors’ choices should depend on their risk appetite and existing liquidity.
- For equity investments to meet long-term goals, investors should consider adopting a balanced approach.
Conclusion
It is better not to get swayed by high past returns while investing. Stocks’ past performance need not be sustained. It is crucial to select funds managed by seasoned fund managers with a good long-term track record.
Having realistic return expectations and giving the investments a 7-10 year time horizon for compounding can work their magic. One should consider reinvesting dividends and increasing the SIP amounts to boost the overall corpus. Most importantly, it is important to stay invested and avoid redemption panic during market corrections.
Frequently Asked Questions
Q1: What is CAGR in the context of SIP and lumpsum investments?
A1: CAGR (Compound Annual Growth Rate) represents the annualised growth rate of an investment over a specified time period. For SIP (Systematic Investment Plan), it calculates growth based on regular investments, while for lumpsum, considers a one-time investment.
Q2: How does CAGR calculation differ between SIP and lumpsum investments?
A2: Calculating CAGR for lumpsum investments is straightforward as it is based on the start and end value of a single investment amount. For SIPs, the calculation is more complex as it considers multiple cash flows at different intervals and their individual growth rates.
Q3: Why is CAGR generally lower for SIP compared to lumpsum investments?
A3: Since SIP investments are staggered over time, the initial instalments take more time to grow compared to the later ones. This reduces the overall growth rate compared to a lumpsum investment, which has the entire amount invested from the start.
Q4: Can SIP ever outperform lump sum in terms of CAGR?
A4: SIPs can outperform lumpsum investments in volatile markets by taking advantage of rupee cost averaging. However, in a consistently rising market, lumpsum investments tend to generate a higher CAGR due to their early exposure to growth.
Q5: Which investment strategy is better for long-term growth: SIP or lumpsum?
A5: The choice between SIP and lumpsum investing should depend on the existing market conditions, risk tolerance, and cash flow availability. SIPs provide risk mitigation and discipline, while lumpsum offers higher growth potential in bullish markets.
Q6: Is CAGR the only metric to compare SIP and lumpsum investments?
A6: Other financial metrics like XIRR (Extended Internal Rate of Return) and absolute returns are also used to evaluate and compare the performance of SIP and lumpsum investments, considering cash flow timing and overall portfolio growth.
