Naturally, you want to see how much your investment has increased. However, figuring this out isn't always simple. Occasionally, money is added at different times, occasionally it is taken out before the end, and investments increase at varying rates.
Two popular tools are used to clearly measure growth: XIRR (Extended Internal Rate of Return) and CAGR (Compound Annual Growth Rate).
While these are ways to determine the "real" return on your investments, their effectiveness varies depending on the circumstances.
When you invest a lump sum and leave it unaltered, CAGR is straightforward and effective. However, when you make numerous little investments over time, such as in a Systematic Investment Plan (SIP), XIRR performs better.
What is CAGR (Compound Annual Growth Rate)?
The acronym CAGR represents Compound Annual Growth Rate. It is a method of calculating an investment's average annual growth over time. Consider it the "smooth" growth rate that, if it increased at the same rate each year, would bring your investment from its initial quantity to its final value.
As an illustration, let's say you invested ₹1,00,000 in a mutual fund. Five years later, it has increased to ₹1,61,051. The CAGR illustrates the consistent annual growth rate that would raise ₹1,00,000 to ₹1,61,051 during a five-year period.
Calculating CAGR With an Example
(Final Value ÷ Initial Value) ^ (1 ÷ Years) - 1
If we figure it out:
CAGR is equal to (1.61051) ^ 0.2 - 1 = 0.10 or 10% = (₹1,61,051 ÷ ₹1,00,000) ^ (1 ÷ 5) - 1.
In other words, your money increased by 10% annually on average.
Additionally Read: How to Calculate CAGR
Key Importance of CAGR
Simple to Understand: Rather of displaying annual fluctuations, it displays a single percentage.
Ideal for One-Time Investments: When you invest money once and let it grow, it works nicely.
Aids in Comparison: Comparing two investments is simple. For instance, you can tell which fund did better if it exhibits a 10% CAGR and another 8% CAGR.
Smoothes Out Fluctuations: Although real returns may fluctuate annually, CAGR gives the impression that they are constant.
What is XIRR (Extended Internal Rate of Return)?
Let's now discuss XIRR. The Extended Internal Rate of Return is what this is short for. It is employed when you do not invest all of the money at once and is more sophisticated than CAGR. Alternatively, you could withdraw some in between or add modest amounts at various intervals.
Calculating XIRR With an Example
Consider it similar to grades in school. "On average, you improved 12% per year," your teacher would comment if you received 50 in Class 6 and 80 in Class 10. That's precisely how CAGR operates.
CAGR is predicated on a one-time investment. However, in reality, we frequently:
Make monthly SIP investments.
Later, add additional cash.
Get dividends.
Before the conclusion, redeem (withdraw) a portion of the funds.
CAGR is unable to manage all of these. XIRR is useful in this situation.
Another example of XIRR
Assume:
On January 1, 2020, you invest ₹50,000.
After six months, you add ₹30,000.
On January 1, 2021, you receive a dividend of ₹5,000.
On July 1, 2021, you made an additional ₹20,000 investment.
Ultimately, you withdraw everything and receive ₹85,000 back on January 1, 2022. Since the cash flows are not equal and do not occur simultaneously, you cannot simply use CAGR to determine your return. You use XIRR instead.
Your annual return can be computed by entering all of these cash flows (investments and withdrawals) together with dates into Excel and using the XIRR formula. In this instance, it might equal about 12.34%.
Key Importance of XIRR
Manages Unpredictable Cash Flows: Ideal for SIPs, sporadic investments, and additions and withdrawals.
Provides Real Return: This displays the actual yearly return while taking into account the inflow and outflow of funds.
Used in Financial Planning: Given that actual life typically involves numerous transactions, this tool is quite helpful for long-term planning.
Key Differences Between XIRR and CAGR
Feature
| XIRR
| CAGR
|
Cash Flow
| Handles irregular cash flows
| Assumes a single lump sum investment
|
Use Case
| Best for SIPs, staggered investments
| Best for lump-sum investments
|
Flexibility
| Accounts for multiple inflows/outflows
| Assumes reinvestment without withdrawals
|
Calculation Complexity
| More complex, needs date and amount tracking
| Simple, requires only start and end values
|
Investment Type
| Suitable for investments with multiple transactions
| Suitable for single lump-sum investments
|
Flexibility
| Accounts for irregular cash flows
| Works only for fixed investment periods
|
Calculation Complexity
| Requires an iterative calculation approach
| Uses a simple formula
|
Application
| Commonly used for SIPs, dividends, and business cash flows
| Used for fixed deposits, bonds, and mutual funds
|
Accuracy
| More precise for real-world investments with varying cash flows
| Effective for stable investment scenarios
|
XIRR suits multiple cash-flow investments, offering detailed performance analysis, while CAGR simplifies growth for single investments. Understanding their differences helps investors choose the right metric for better financial decisions.
Benefits of XIRR and CAGR
Precision in Returns XIRR helps measure returns when money is invested or withdrawn at different times, making it perfect for SIPs. CAGR, on the other hand, shows simple yearly growth for lump-sum investments.
Comparison Across Investments Both XIRR and CAGR allow easy comparison of different investments. CAGR works well for single, one-time investments, while XIRR is better for varied cash flows, giving clearer portfolio insights.
Decision-Making Tool Knowing XIRR versus CAGR helps investors choose wisely. By selecting the right metric for their style, they can plan smarter, set goals properly, and improve their overall investment strategy.
Long-Term Performance CAGR shows steady growth trends over long periods, while XIRR adapts to frequent transactions. Together, they provide complete performance tracking, ensuring investors understand returns and maximise financial success.
Conclusion
It is similar to understanding two distinct methods of progress measurement to comprehend CAGR and XIRR. CAGR is easy to understand. It provides you with a tidy, typical growth rate. The best results are obtained from a single investment that is left unaltered.
These two resources will help you along the way, whether you're saving for college, purchasing a home, or accumulating long-term wealth.
