Extended Internal Rate Of Return (XIRR) and Compound Annual Growth Rate (CAGR) are two important metrics most investors consider while reviewing the performance of their mutual fund investments. Although both metrics are crucial to track performance, they are used in different scenarios. Hence, for any investor, it becomes essential to understand these metrics to track their portfolio performance accurately.
This article will educate you about CAGR and XIRR metrics, their formulas, how they differ and when to use each.
What is XIRR?
Extended Internal Rate of Return (XIRR) is a way to figure out the annualized return on an investment when money goes in and out at different times. It’s especially helpful for investments like mutual funds, where you might invest or withdraw money on different dates.
Think of XIRR as a smart calculator. It looks at how much money you put in, how much you got back and when each transaction happened. Here, the timing matters because money you have today has more potential to grow than the same amount in the future.
Let’s suppose you invest Rs 5,000 every month in a mutual fund through SIPs for a year and then you get a lump sum at the end. XIRR considers each monthly investment and the final payout to give you a better idea of your actual returns, instead of just showing a simple average. XIRR shows that the earlier an investment or installment is made, the more time it has to grow compared to those made later. Thus, it presents a more informed picture of the actual annualised return.
XIRR is great for investments with multiple cash flows, giving you one clear return rate that accounts for all the ins and outs. This makes it easier to compare different investment options.
What is CAGR?
Compound Annual Growth Rate (CAGR) is a simple way to figure out how much your investment has grown each year on average over the investment period. It assumes the growth happened steadily, even if it didn’t in reality.
To calculate CAGR, you only need three things: the starting value, the ending value and how long you stayed invested. This makes it easy to compare different investments.
Let’s suppose you invested Rs. 1 lakh in a stock five years ago and it’s worth approximately Rs. 1.61 lakh today; then the CAGR is 10%. This means your investment grew at an average of 10% per year, even if some years were better or worse than others.
CAGR is especially useful for long-term investments because it smooths out the short-term ups and downs. It is often used to compare the performance of stocks, mutual funds or entire markets over the same time period.
Difference Between XIRR and CAGR
Cash Flow Consideration
CAGR: Looks at only the starting and ending amounts, ignoring any money added or withdrawn in between.
XIRR: Includes all the investments and withdrawals made at different times.
Flexibility
CAGR: Works best for single, lump sum investments.
XIRR: Perfect for situations where money is invested or withdrawn irregularly or through an SIP.
Real-World Use
CAGR: Simple but less accurate if there are multiple transactions.
XIRR: Gives a more precise and realistic return for investments with complex cash flows.
Ease of Calculation
CAGR: Easy to calculate manually.
XIRR: Needs tools like Excel or financial calculators to work out.
Formula and Numeric Example of XIRR
XIRR is a financial tool that helps calculate the annualised return on investments when cash is flows happen at different times. In Excel, you can calculate it using the formula =XIRR(values, dates), where ‘values’ are the amounts of money you invest or receive and ‘dates’ are the exact dates these cash flows happen.
For example, let’s say you Invest Rs. 1 lakh in a business on January 1, 2020. Add Rs. 50,000 more on July 1, 2020. Get Rs. 1.60 lakh on December 31, 2020. In this case:
Values: -1,00,000 (outflow), -50,000 (outflow), +1,60,000 (inflow)
Dates: 1/1/2020, 7/1/2020, 12/31/2020
When you put these numbers into the XIRR formula in Excel, it gives you the annualised return, taking into account when each cash flow occurred. This makes XIRR a precise way to measure returns for investments with irregular transactions.
Formula and Numeric Example of CAGR
CAGR shows how much an investment grows on average each year over a longer period. It assumes the growth is steady, even if it wasn’t. The formula is:
CAGR = (Ending Value / Starting Value)^(1 / Number of Years) – 1
For example, imagine you invested Rs. 50,000 in a mutual fund on January 1, 2015. By January 1, 2020, the value of your investment increased to Rs. 65,000.
Starting Value: Rs. 50,000
Ending Value: Rs. 65,000
Time Period: 5 years
Using the formula, the CAGR comes out to about 5.4%. This means your investment grew at an average rate of 5.4% every year over those 5 years. CAGR helps you understand the consistent annual growth of your investment, even if the actual growth varied year to year.
Conclusion
Deciding between CAGR and XIRR depends on how you’ve invested. If you made a one-time lump sum investment and want to see its average growth rate, CAGR is the right choice. But if your investment involves multiple transactions, like regular investments or withdrawals, XIRR gives a more accurate picture of your returns.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
