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XIRR vs CAGR: What to Know?
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When measuring investment performance, two commonly used metrics are Extended Internal Rate of Return (XIRR) and Compound Annual Growth Rate (CAGR). Both XIRR and CAGR are essential tools for investors as they provide a standardised way of evaluating the return on investment over a specific period.
However, these two metrics are often confused and used interchangeably, leading to misinterpreting investment performance. Therefore, investors must understand the concept of XIRR vs. CAGR to make informed decisions.
What is XIRR?
XIRR, which stands for Extended Internal Rate of Return, is a financial metric widely used to evaluate investment performance. It considers the timing and amount of cash flows over a given period. Unlike traditional metrics like CAGR, XIRR accounts for irregular cash flows and multiple periods, making it a valuable tool for analysing investments with complex cash flow patterns.
By calculating the rate of return that can bring the present value of all cash inflows and outflows to zero, XIRR provides a comprehensive measure of investment profitability. This allows investors to assess the true performance of an investment and make more informed decisions.
What is CAGR?
CAGR, or Compound Annual Growth Rate, is another important financial metric used in investment analysis. It measures the annual rate at which an investment grows over a specific period, assuming it has compounded over time. CAGR is often used to assess the performance of investments with consistent growth patterns, such as stocks or mutual funds.
It provides a smooth and standardised measure of growth, allowing investors to compare different investments equally. The CAGR formula considers the initial investment value, the final investment value, and the years the investment has been held.
Difference Between XIRR and CAGR
Parameter
XIRR
CAGR
Meaning
Extended Internal Rate of Return, accounts for variable cash flows.
Compound Annual Growth Rate, measures steady growth over time.
Calculation
Uses specific dates and amounts of cash flows.
Calculates using beginning value, ending value, and time period.
Timing
Considers the exact timing of cash flows.
Assumes a single investment at the start without further inflows.
Inclusion of Cash Flows
Includes multiple, irregular cash flows over the investment period.
Typically considers a singular initial investment only.
Investment Type
Ideal for investments with irregular investments, like SIPs.
Suited for lump-sum investments without additional contributions.
Rate of Return
Provides a rate that accurately reflects all cash flow timings.
Offers a simplified annual growth rate ignoring specific timings.
Complexity
More complex due to varying cash flows and their timings.
Simpler as it assumes uniform growth over periods.
Accuracy
Higher accuracy for irregular cash flows.
May not accurately reflect performance for non-uniform investments.
Formula and Numeric Example of XIRR
XIRR, or Extended Internal Rate of Return, is a financial metric used to calculate the return on investments with irregular cash flows. In Excel, it's calculated with =XIRR(values, dates), where "values" are the cash flows (money in and out) and "dates" are when these cash flows happen.
Example:
Suppose you invested Rs. 1,00,000 in a business on January 1, 2020. You then invested an additional Rs. 50,000 on July 1, 2020, and received a total amount of Rs. 1,60,000 back on December 31, 2020.
To find the XIRR:
Inputting these values and dates into the XIRR formula in Excel calculates the XIRR percentage, indicating the annualised return on investment, considering the specific timing of each cash flow.
Formula and Numeric Example of CAGR
CAGR, or Compound Annual Growth Rate, is a measure used to express an investment's yearly growth rate over a period longer than one year, assuming steady growth during that period. The CAGR formula is:
CAGR = (Ending Value / Starting Value)^(1 / Number of Years) – 1
Example:
Suppose you put Rs. 50,000 into a mutual fund on January 1, 2015; on January 1, 2020, this investment grew to Rs. 65,000.
By the formula, the CAGR would be around 5.4%.
This means the investment grew at an average annual rate of 5.4% over the 5 years, showing how much your money increased each year on average.
XIRR vs CAGR: Pros and Cons
Parameter
XIRR
CAGR
Pros
- Accounts for cash flows at irregular intervals, making it versatile for various investment types.
- Provides a more accurate reflection of the actual return, especially useful for SIPs or investments with multiple cash inflows and outflows.
- Useful for analysing the performance of projects or investments that do not have a constant investment flow.
- Simple to calculate and understand, making it accessible for beginners.
- Offers a clear picture of an investment’s annual growth rate over time, assuming steady growth.
- Ideal for comparing the performance of different investments over a fixed period.
Cons
- More complex to calculate due to the need to accurately track dates and amounts of all cash flows.
- Can be misleading if cash flows are not properly accounted for, as the timing significantly impacts the result.
- Does not account for the timing of cash flows, which can lead to inaccuracies in reflecting the true return of investments with multiple or irregular cash flows.
- Oversimplifies the performance of investments, potentially ignoring volatility and other factors affecting returns.
FAQs
Why is XIRR used to calculate returns from SIP and not CAGR?
XIRR is used because it can accurately account for multiple cash flows at irregular intervals, which is characteristic of SIPs (Systematic Investment Plans), unlike CAGR.
Which is better, XIRR vs CAGR?
Neither is categorically better; XIRR is preferable for investments with irregular cash flows, while CAGR is suited for evaluating single, lump-sum investments over time.
Which is better: CAGR or absolute return?
The choice depends on context; CAGR is useful for understanding an investment's growth rate over time, while absolute return measures the total return without considering the investment period.
What XIRR is good?
A "good" XIRR outperforms the benchmark or average returns of similar investments and ideally outpaces inflation.
Are annualised returns and CAGR the same?
Yes, annualised return and CAGR are essentially the same. Both indicate an investment's compounded annual growth rate.
Can we convert XIRR to CAGR?
Direct conversion from XIRR to CAGR isn't feasible because the two calculate returns based on different assumptions about cash flow timing.
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