XIRR vs CAGR: Differences, Total Rates, Returns, Examples & Full Form
While calculating the returns on your investments, you might have used metrics like CAGR and XIRR. While both are useful tools, they have certain differences in their calculations and application.
Understanding these differences can help you make informed decisions about your investment strategies and will help you achieve your financial goals. In this blog, we will explore the differences between CAGR and XIRR, their advantages and disadvantages, and situations where one may be more appropriate than the other. Let us now understand what is XIRR to CAGR.
What is XIRR?
XIRR, or Extended Internal Rate of Return, serves as a crucial financial gauge in the stock market, determining the rate of return on an investment based on its cash flows. It encompasses all cash inflows and outflows, such as dividends and capital gains, over a specific timeframe, indicating the returns generated.
For portfolio investors, XIRR proves invaluable in assessing and distinguishing the performance of individual stocks within their portfolios. This metric aids in identifying which shares are causing losses or offsetting gains.
When dealing with Systematic Investment Plans (SIP), the calculation of returns becomes intricate due to multiple investments with varying prices and time periods. Consequently, XIRR is commonly employed to compute returns for SIP, streamlining the process for investors.
What is CAGR?
CAGR, short for Compound Annual Growth Rate, serves as a prominent metric for gauging investment returns. Unlike absolute return, which measures the point-to-point return without considering time, CAGR captures the average annual return by factoring in the initial investment, final value, and elapsed time. This preference for CAGR arises from its ability to facilitate comparisons of returns across diverse asset classes. Now, let’s delve into the calculation of Compound Annual Growth Rate or CAGR.
What is the Difference Between XIRR and CAGR?
The following table will analyze the difference between CAGR and XIRR:
| Basis | XIRR | CAGR |
|---|---|---|
| Meaning | Calculates rate of return based on both investments and cash flows. | Calculates rate of return based only on the beginning and ending investment value. |
| Calculation | Calculates returns of irregular cash flows | Calculates returns of constant investments |
| Timing | Takes into account the timing of cash flows. | Does not consider the timing of cash flows. |
| Inclusion of Cash Flows | Requires all cash flows to be present. | Requires the initial and final investment amounts only. |
| Investment Type | Can handle investments with multiple inflows and outflows. | Only applicable to investments with a fixed investment amount. |
| Rate of Return | Considers the internal rate of return. | Considers the average annual growth rate. |
| Complexity | More complex calculation method. | Simple calculation method. |
| Accuracy | More accurate as it considers the timing and value of each cash flow. | Less accurate as it does not consider the timing and value of each cash flow. |
Understanding the Difference Between XIRR and CAGR
Meaning of CAGR and XIRR
CAGR stands for Compound Annual Growth Rate and is a measure of the average annual growth rate of an investment over a specific period of time, assuming that the investment has grown at a steady rate each year.
On the other hand, the meaning of XIRR in SIP stands for Extended Internal Rate of Return and is a financial tool used to calculate the internal rate of return (IRR) of a series of cash flows that occur at irregular intervals. It takes into account the time value of money and provides a more accurate measure of return on investment, especially for investments with irregular cash flows.
XIRR vs CAGR: What’s the Difference Between their Calculation?
CAGR is calculated by taking the nth root of the total return and subtracting 1, where n is the number of years in the investment period. XIRR, on the other hand, is calculated by using a formula that solves for the rate of return that makes the net present value of all cash flows equal to zero.
The main difference between the two is that CAGR assumes that the investment grows at a steady rate over time, while XIRR accounts for irregular cash flows and assumes that money is invested at different times with different returns. Additionally, while CAGR only takes into account the beginning and ending values of an investment, XIRR meaning in mutual fund considers all cash flows throughout the investment period.
Examples of CAGR and XIRR
When it comes to calculating the returns, both CAGR and XIRR give different results. Let’s understand why there is a difference between the results with the help of an example.
Suppose an investor invested Rs. 10,000 in a mutual fund on January 1, 2018. The mutual fund pays out dividends of Rs. 500 each year, and the investor decides to reinvest these dividends in the fund. On December 31, 2021, the value of the mutual fund is Rs. 14,000.
To calculate the CAGR of this investment, we can use the formula:
CAGR = (Ending Value / Beginning Value)^(1/n) – 1
where n is the number of years. Plugging in the numbers, we get:
CAGR = (14000/10000)^(1/4) – 1 = 0.1151 or 11.51%
Now, let’s calculate the XIRR for this investment. We need to create a cash flow table that includes the initial investment of Rs. 10,000 and the annual dividends of Rs. 500 that were reinvested in the fund. The cash flow table would look like this:
| Date | Cash Flow |
| 01/01/2018 | ₹(10,000) |
| 01/01/2019 | ₹(500) |
| 01/01/2020 | ₹(500) |
| 01/01/2021 | ₹(500) |
| 31/12/2021 | ₹14,000 |
If you are wondering how is XIRR calculated, look no further! Using an XIRR calculator, we get an XIRR of 12.33%.
So, in this example, we see that the CAGR and XIRR are both measures of returns, but they take into account different factors. The CAGR only considers the beginning and ending values of the investment, while the XIRR takes into account the timing and amount of all cash flows.
Limitations of CAGR
The compound growth rate is a valuable tool for assessing investment performance, yet it has limitations. These include:
- Assumption of Constant Growth: It presupposes a consistent growth rate throughout the entire analysis period, which may not align with real-world scenarios where market conditions and external factors lead to fluctuations.
- Limited Applicability to Diverse Risk Levels: The compound annual growth rate might not be the most suitable metric for comparing investments with varying risk levels. It overlooks return variability, meaning a high-risk investment could show a higher CAGR than a low-risk one, despite the latter potentially delivering more stable returns over time.
Limitations of XIRR
The XIRR return method, while offering undeniable advantages, comes with its own set of limitations. Let’s explore these:
- Accurate Cash Flow Data Required: XIRR relies on precise and complete cash flow information, encompassing both date and amount details. Inaccuracies or incompleteness in the data can impact the precision of the XIRR calculation.
- Sensitivity to Small Data Changes: XIRR proves to be a sensitive metric, susceptible to even minor alterations in cash flow data. This sensitivity poses a challenge when comparing different investments or basing decisions solely on the XIRR return.
- Not Universally Applicable: While suitable for investments featuring irregular cash flows, such as private equity or real estate, XIRR may not be appropriate for those with consistent cash flows, like bonds or annuities.
XIRR vs CAGR: What are their Advantages and Disadvantages?
Advantages of XIRR
- Accounts for Uneven Cash Flows: XIRR takes into account the time value of money and considers the timing of cash flows, making it useful for investments with irregular or uneven cash flows.
- Provides Accurate Return Calculation: XIRR provides a more accurate calculation of the return on investment as it accounts for both the magnitude and timing of cash flows.
Disadvantages of XIRR
- May be Difficult to Calculate Manually: Calculating XIRR manually can be challenging, especially for investments with numerous cash flows and changing rates of return.
- May Not Provide a Clear Picture of Long-Term Performance: XIRR calculates the annualized return over the entire investment period, which may not give a clear picture of the long-term performance of the investment.
Now, let’s examine the advantages and disadvantages of CAGR.
Advantages of CAGR
- Simple to Calculate: CAGR is a straightforward formula that can be easily calculated using basic arithmetic.
- Provides a Clear Picture of Long-Term Performance: CAGR provides a clear picture of the average annual return of an investment over a specific period, making it useful for long-term investments.
Disadvantages of CAGR
- Does Not Account for the Timing of Cash Flows: CAGR assumes that cash flows are evenly spaced over the investment period, which may not be the case for investments with irregular or uneven cash flows.
- Can Be Misleading for Volatile Investments: CAGR may not accurately reflect the performance of an investment with high volatility, as it assumes a steady rate of return over the entire investment period.
CAGR vs XIRR for SIP: Which One is Better?
Both CAGR and XIRR are useful tools for analyzing the performance of SIPs (Systematic Investment Plans).
However, in the case of SIPs, XIRR in mutual fund is generally considered the more appropriate method for calculating returns. This is because SIPs involve investing a fixed amount of money at regular intervals, which can result in irregular cash flows. XIRR takes into account the exact timing and amount of each cash flow, making it a more accurate representation of the true returns of a SIP.
CAGR, on the other hand, assumes a constant rate of return over the entire investment period, which may not accurately reflect the returns of a SIP.
How to Check CAGR and XIRR on smallcases?
Check out the images below to understand how you can analyze the CAGR vs XIRR on smallcases:
1. CAGR
2. XIRR
XIRR vs CAGR: Which Should You Employ and When?
Situations where CAGR is the more appropriate method of calculating returns:
- When the investment has a fixed rate of return over a period of time
- When the investment has a fixed holding period
- When the investment is a simple investment with no cash flows during the investment period
Examples of investments where CAGR is commonly used:
- Fixed deposits(FDs)
- Types of Bonds
- Mutual funds with a fixed holding period
- Real estate investments with fixed holding periods
Situations where XIRR is the more appropriate method of calculating returns:
- When the investment has irregular cash flows, such as in the case of SIPs or mutual funds with frequent investments or withdrawals
- When the investment has varying rates of return over the investment period
- When the investment has no fixed holding period
Examples of investments where XIRR is commonly used:
- Systematic Investment Plans (SIPs) in mutual funds
- Investments with multiple cash inflows and outflows, such as in real estate
- Investments in venture capital and private equity funds where there is no fixed holding period and cash flows are unpredictable.
To Wrap It Up…
In conclusion, both XIRR and CAGR are useful measures of investment returns, but they have their own strengths and weaknesses.
CAGR is a simple method that calculates the average annual growth rate of an investment, making it useful for analyzing long-term investments.On the other hand, XIRR is a more complex method that accounts for the time value of money and cash inflows/outflows, making it more suitable for investments with irregular cash flows.
FAQs
XIRR is a better measure of returns from SIP than CAGR. This is because it takes into account the timing of the investments.
It depends on the type of investment. For investments with regular cash flows, such as lump sum investments, CAGR is a good enough measure of returns. However, for investments with irregular cash flows, such as SIPs, XIRR is a better measure of returns.
For short-term investments, focus on absolute return. For longer durations, use CGAR for a clearer perspective. CAGR facilitates easy comparison of investments held for varying periods.
CAGR is also called annualized return. It evens out investment return fluctuations over time. It’s a valuable tool for comparing investments with varying returns across different periods.
Generally, an XIRR above 12% signals strong performance for equity funds. For debt funds, anything exceeding 7.5% is considered favorable. If you are wondering how much XIRR is good, consider consulting a financial advisor.
XIRR means extended internal rate of return, calculates the annualized return on investment with irregular cash flows.
XIRR accurately considers the timing and amount of each cash flow, providing a precise portrayal of SIP returns. In contrast, CAGR assumes a consistent return rate throughout the investment period, potentially misrepresenting SIP returns.
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