XIRR VS CAGR

When evaluating investment returns, two commonly used metrics are XIRR (Extended Internal Rate of Return) and CAGR (Compound Annual Growth Rate). While both help in assessing the performance of an investment, they serve different purposes and are suited for different scenarios

Extended Internal Rate of Return (XIRR)

XIRR (Extended Internal Rate of Return) is a powerful metric used to calculate the actual returns on investments with irregular cash flows. Unlike simple return calculations, XIRR accounts for multiple investments and withdrawals made at different times, making it particularly useful for Systematic Investment Plans (SIPs), real estate investments, or any scenario where money is added or withdrawn at varying intervals.

How is XIRR Calculated?

XIRR is calculated using the formula-

XIRR=(NPV(CashFlows,r)/InitialInvestment)∗100

XIRR can be easily calculated using Excel or Google Sheets by using the =XIRR(values, dates, Interest) function, where:

• Values = List of cash flows (both positive and negative )

• Dates = Corresponding dates of transactions

• Interest = An estimated return value (which you expect , optional )

XIRR UseCase Example 

Imagine you contribute ₹10,000 every month into a mutual fund through an SIP. After four years (48 months), the total invested amount is ₹4.8 lakh. However, this amount was not invested at once by you and each ₹10,000 installment was invested at a different time and earned returns differently over different time periods

A simple return calculation would not accurately reflect the portfolio’s performance because each investment installment has a different holding period and return. XIRR solves this problem by considering each cash inflow and outflow along with the time they were made, providing a more accurate annualized return on the entire portfolio. Helping you to understand the returns for your investments more accurately.

Benefits of XIRR

1. Accurately Measures Returns for Irregular Cash Flows

   
   

   Unlike CAGR, which assumes a lump sum investment, XIRR considers multiple investments and withdrawals made at different times. This makes it ideal for Systematic Investment Plans (SIPs), real estate, or any portfolio with varying cash flows.

   
   

2. Provides a Realistic Annualized Return

   
   XIRR calculates the true annualized return, making it easier to compare investments with different cash flow patterns. This helps investors assess their actual returns over time.

   
   

3. Accounts for Investment Timing

   
   Since each investment installment may have a different holding period and return, XIRR adjusts for the time value of money, ensuring a more precise return calculation.

   
   

4. Helps in Portfolio Performance Tracking

   
   For investors managing a portfolio with multiple buy and sell transactions, XIRR gives a more comprehensive view of how the entire portfolio has performed over time.

Cons of XIRR

1. Complex to Calculate Manually

   
   

   Unlike CAGR, which has a straightforward formula, XIRR requires iteration and trial-and-error to find the correct return. 

   
   

2. Highly Sensitive to Cash Flow Timing

   
   

   Since XIRR heavily depends on the dates of investments and withdrawals, even a small change in cash flow timing can significantly impact the result. This makes it less reliable if the dates are inaccurate or missing.

   
   

3. Can Produce Misleading Results in Certain Cases

   
   

   If an investment has very large withdrawals or irregular cash flow patterns, XIRR can sometimes give extremely high or unrealistic return values, which may not reflect the true.

   
   

4. Not Suitable for Comparing Fixed Returns

   
   

   For investments like Fixed Deposits (FDs) or Bonds, where returns are fixed and predictable, XIRR is unnecessary and can complicate comparisons. CAGR or absolute returns may be better suited for such cases.

   
   

5. Can Give Multiple or No Solutions

   
   

   In some cases, when cash flows fluctuate significantly, the mathematical equation used to calculate XIRR may have multiple solutions (more than one possible XIRR value) or no solution at all, making interpretation difficult.

   
   

What is CAGR (Compound Annual Growth Rate)?

CAGR (Compound Annual Growth Rate) is a metric that helps investors measure the annualized growth rate of an investment over a period of time. It provides a "smoothed" rate of return, assuming the investment grew at a steady rate every year, even if in reality, the returns fluctuated.

CAGR is useful for comparing different investments over varying time periods, as it standardizes the return into a single annual percentage, making it easier to assess performance.

Formula of CAGR 

CAGR = (Final Value / Initial Value)^(1 / n) - 1

Where:

• Final Value = Value of the investment at the end of the period

• Initial Value = Value of the investment at the start of the period

• n = Number of years the investment was held

CAGR UseCase Example 

Investment A

• Initial Value = ₹50,000

• Final Value = ₹5,00,000

• Number of Years (n) = 12

CAGR = (5,00,000 / 50,000)^(1 / 12) - 1

CAGR = (10)^(1 / 12) - 1

CAGR = 1.2114 - 1

CAGR = 0.2114 or 21.14%

Investment B

• Initial Value = ₹80,000

• Final Value = ₹3,50,000

• Number of Years (n) = 8

CAGR = (3,50,000 / 80,000)^(1 / 8) - 1

CAGR = (4.375)^(1 / 8) - 1

CAGR = 1.1994 - 1

CAGR = 0.1994 or 19.94%

Investment A had a CAGR of 21.14%, meaning it grew at an average annual rate of 21.14% over 12 years.

Investment B had a CAGR of 19.94%, meaning it grew at 19.94% per year over 8 years.

Even though Investment A created more wealth overall, Investment B grew at a slightly slower pace but over a shorter period.

Benefits of CAGR

1. Simple and Easy to Understand

   
   

   CAGR provides a single percentage that represents the annual growth rate, making it easy to compare investments.

   
   

2. Useful for Long-Term Investments

   
   

   It helps investors evaluate the performance of stocks, mutual funds, and other assets over multiple years.

   
   

3. Standardized Growth Comparison

   
   

   Since CAGR smooths out returns, it allows for the comparison of different investments, regardless of their timeframes.

   
   

4. Eliminates Short-Term Market Fluctuations

   
   

   Unlike absolute returns, which can be misleading due to short-term volatility, CAGR gives a more stable long-term growth rate.

   
   

5. Applicable Across Different Asset Classes

   
   

   CAGR can be used for stocks, mutual funds, real estate, and even business revenue growth.

Cons of CAGR

1. Ignores Market Volatility

   
   

   CAGR assumes a constant rate of return, but in reality, investments fluctuate over time.

   
   

2. Doesn’t Consider Intermediate Cash Flows

   
   

   It does not account for periodic withdrawals or additional investments made during the investment period. (XIRR is better for this.)

   
   

3. Not Suitable for Short-Term Investments

   
   

   CAGR works best for long-term investments (3+ years). For short-term investments, absolute returns are more relevant.

   
   

4. Can Be Misleading in Case of Negative Returns

   
   

   If an investment declines significantly and then recovers, CAGR may show an inflated return that does not reflect real performance.

   
   

5. Assumes Reinvestment at the Same Growth Rate

   
   

   CAGR assumes that profits are reinvested at the same rate, which may not be practical due to changing market conditions.

Difference between XIRR VS CAGR

Conclusion

Both XIRR and CAGR are important metrics for measuring investment returns, but they serve different purposes.

• CAGR is ideal for evaluating lump sum investments with a fixed holding period, providing a simple and standardized annualized return.

• XIRR, on the other hand, is better suited for investments with multiple cash flows (such as SIPs or real estate), as it considers both the timing and amount of each transaction.

If your investment has irregular deposits or withdrawals, XIRR is more accurate. However, if you’re analyzing a single one-time investment, CAGR is sufficient.