Understanding XIRR and CAGR In Investing
Understanding financial jargon is crucial to navigating your way through the intricate world of financial products. Whether you are a novice investor or someone with experience, terms like XIRR and CAGR might leave you scratching your head.
Don’t worry, as this blog is designed to demystify these essential concepts and help you gain a firm grasp on their importance in evaluating your investment performance.
What is CAGR?
CAGR stands for Compounded Annual Growth Rate. It is a widely-used method for calculating long-term growth. In the context of investments, CAGR is employed to determine long-term returns when you are exclusively looking for growth between two specific points over a certain period. It informs you of the annualized growth of your investment.
For example, if you invested Rs 10,000 in October 2018, which has grown to Rs 20,000 in October 2021, you will know it took 3 years for your money to double. In other words, you will know you have earned 100% returns in 3 years.
However, to understand the annual return, you need to apply the CAGR calculation. In this case, it will be 25.99%.
How to Calculate CAGR?
To calculate the annualized growth over a period, you need to use the formula:
CAGR = [(End Value/Starting Value)^1/t] – 1, where t = time in years
In the example above, our starting value is Rs 10,000, our end value is Rs 20,000, and the time in years is 3. Thus, our CAGR will be
[(20,000/10,000)^1/3]-1,
which turns out to be 25.99%.
What is XIRR?
XIRR stands for Extended Internal Rate of Return. In simple terms, it is useful for calculating returns on investment when a portfolio has multiple inflows or outflows. As most investors invest in mutual funds through SIPs, XIRR can be a valuable formula to calculate the average annualized return on the entire portfolio.
How is XIRR Calculated?
Let’s understand this with an extension of the previous example. Suppose you started investing Rs 10,000 every year for three years and are looking at a final amount of Rs 60,000 at the end of 5 years.
In this case, it will be difficult to determine the annualized return for each investment and then a combined value. Instead, you can use the XIRR function or formula in a spreadsheet for this calculation.
In other words, your first installment had 5 years to grow, the second installment had 4 years, and the third installment only had 3 years to grow. So, if you look at the final amount of Rs 60,000, you might think that your investment has doubled, or the absolute return on your investment is 100%, which is also accurate.
However, that doesn’t take into account the time variations.
Now, if you use the XIRR function in spreadsheets or an XIRR calculator available online, you will find that the XIRR or the annualized average return on your investments is 18.61%.
Difference between XIRR and CAGR
| XIRR | CAGR | |
| Definition | Measures the average rate earned by every cash flow invested during the period | Measures the compound growth rate |
| Cash Flows | Considers multiple cash flows | Doesn’t consider multiple cash flows |
| Return | Annualized Return | Absolute Return |
| Applicability | Applicable for all types of cash flows Suitable for long-term lump-sum investment return calculations | Applicable for all types of cash flows Suitable for long-term lump-sum investment return calculations |
Final Considerations
Grasping fundamental concepts, such as the distinction between XIRR and CAGR and the significance of these metrics in their investment journey, is crucial for investors. Keeping up with developments in your portfolio and comprehending all the intricacies greatly contributes to investment success.
FAQs
The key difference between CAGR and XIRR lies in their application. CAGR calculates returns solely between two points in time, while XIRR tackles returns in scenarios with multiple transactions or varying investment timelines.
As a result, CAGR is more useful for determining the annualized return on a savings bank deposit over several years, whereas XIRR is necessary if you want to calculate returns from mutual fund Systematic Investment Plans or Recurring Deposits.
Determining a good CAGR for a portfolio depends on factors like an investor’s risk tolerance and the financial instruments used for investment. For example, if inflation and interest rates are around 6%, a conservative investor might consider a 6% CAGR from fixed deposits as a good return. In contrast, an aggressive investor pursuing high-risk investments like stocks may expect a good CAGR to be 10% or 15%.
The Internal Rate of Return (IRR), calculated using the XIRR function in Excel, and CAGR are distinct calculation methods suited for different growth patterns and investment types. If you’ve invested a lump sum in a single product or stock and want to calculate the growth rate after a specific period (e.g., 2, 5, or 7.5 years), CAGR is more suitable. On the other hand, if you’ve made periodic share purchases over many years or months or invested in mutual funds through a systematic investment plan, XIRR is the better choice.
