One of the things that everyone using investments needs to ensure they do is to monitor the performance of the investments. For investors, two vital metrics often surface during this evaluation process: Extended Internal Rate of Return (XIRR) and Compound Annual Growth Rate (CAGR). Both quantify returns but are used for different objectives and are suitable for different settings. This blog post breaks down what XIRR and CAGR are, the differences between them, and when to use each to make the most of your investments.
What Is XIRR?
The Evaluation of investments with abnormal cash flow like SIPs and real estate investments is done by a complex financial tool called the Extended Internal Rate of Return (XIRR). As opposed to other efficiency indicators, XIRR evaluates the time that it takes for such inflow or outflow to happen, which makes it highly suitable when it comes to the assessment of investments that may involve irregular patterns of contributions or withdrawals.
How Does XIRR Work?
Let us assume an investor invests ₹ 5,000 every month through SIP in the mutual fund for three years. By the end of the period, the total portfolio base rises to 180, 000. But unlike a lump sum investment of ₹1.8 lakh, the amount invested at different points in time gives a different return on each installment. It can therefore become almost difficult to determine the overall portfolio performance using such simple measures.
This is where XIRR shines. It considers the time value of money and determines the precise return each contribution makes, which gives a true factor of the performance.
The formula for XIRR:
It can be applied to Excel or spreadsheets as follows:
=XIRR(values, dates, [guess])
Importance of XIRR
Here are the key benefits of using XIRR:
- Precision with Irregular Cash Flows: XIRR is very useful in defining the net cash flow of an organization, and more preferable when the cash flows are staggered over time and do not occur concurrently.
- Holistic Performance Tracking: The XIRR considers the returns of many investments and provides a single picture of the portfolio’s performance throughout the period.
- Comparison Across Portfolios: Individuals using mutual funds or assets with non-synchronous cash flows can use XIRR to compare one mutual fund or asset to another.
What Is CAGR?
Compound Annual Growth Rate (CAGR) is an easier measure, which gives the form of constant growth for an investment in a given period. It supposes that investment increases at a fixed rate every year, while in actual practice, returns might increase, decrease, or remain constant.
How Does CAGR Work?
Let’s consider two investments:
- Investment A grows from ₹1 lakh to ₹10 lakh over 15 years (absolute return: 900%).
- Investment B grows from ₹20,000 to ₹1.2 lakh over 10 years (absolute return: 500%).
Looking at these returns at face value, without making any filtration or adjustment for the two different periods, is not appropriate. CAGR resolves this by calculating the average annual growth rate, providing clarity:
- Investment A: 16.59% CAGR
- Investment B: 19.62% CAGR
Hence, although, Investment A generated more amount of wealth, Investment B had a better annualized growth rate than Investment A.
The formula for CAGR:
CAGR = (Final value / Initial value) ^ (1/n) – 1
Importance of CAGR
Here are the benefits of using CAGR for computation:
- Simplified Performance Tracking: This process eliminates the highs and lows of monthly variations which make it easier to determine the growth rate for the long-term.
- Universal Applicability: It is ideal to be used when comparing investments over different periods, be it mutual funds, stocks, or indices.
- Lump-Sum Investments: Most useful when it comes to investments that are made infrequently and once paid for are likely to be held for years.
XIRR vs CAGR: Key Differences
| Aspect | XIRR | CAGR |
| Timing of Investment | Considers exact timing of cash flows. | Ignores timing, focusing on duration. |
| Cash Flow Treatment | Handles multiple/irregular cash flows. | Considers only initial and final values. |
| Use Case | Ideal for SIPs, real estate, or irregular flows. | Best for lump-sum, long-term investments. |
| Calculation | Complex due to varying cash flows. | Simple and straightforward. |
| Accuracy | More accurate for staggered investments. | Effective for consistent growth rates. |
XIRR or CAGR: Which One Should You Use?
When it comes to the selection of XIRR and CAGR, the final decision solely depends on the investor’s pattern and the objective of the analysis.
When to Use XIRR:
- SIPs or staggered investments: XIRR takes into consideration the timing of cash flows which is suitable when valuing mutual fund SIPs.
- Irregular real estate payments: In the case of properties with staggered payments, XIRR gives back correct returns.
- Private equity or venture capital: The unpredictability of cash inflow and outflow is the primary reason why XIRR comes in handy.
When to Use CAGR:
- Lump-Sum Investments: In case of one-time investment in mutual funds or stocks.
- Comparing Long-Term Options: Due to its ease of computation, CAGR is applicable for analyzing and comparing distinct investment products.
- Analyzing Trends: It is used to assess the market indices and portfolios over long intervals of time.
Practical Example
For instance, if you have invested ₹5,000 per month in a mutual fund SIP and need an overall return after three years on your investment, choose XIRR. On the other hand, if you invested ₹1 lakh in a company’s stock once, and never got a chance to adjust your holdings for five years, CAGR would show you the clear annualized rate of growth.
Conclusion
XIRR and CAGR are the two most critical figures that tell you about your investments. While XIRR helps analyze the investment proposition having cash inflow happening in different months, CAGR is much easier to evaluate the investment proposition with lump-sum investments. In picking the right metric for an investment situation, one can make appropriate decisions that enhance the type of financial outcome one wants for their investment.
FAQs
1. Why is XIRR preferable over CAGR for SIPs?
XIRR takes into consideration occasional cash flows, which makes it appropriate when calculating returns from investments made in stages such as SIPs in which each installment is made at different times.
2. Can you convert XIRR to CAGR?
No, as both representativity depend on different assumptions about cash flow as well as timing, its conversion is not possible.
3. What is a good XIRR?
A good XIRR is one that is higher than benchmark returns and has a higher value than inflation rates implying that the portfolio is healthy.
4. Are CAGR and annualized returns the same?
Indeed, CAGR can be calculated as an annualized return which reflects continuous cumulative growth.
