Many new investors in various financial products are greeted by multiple terms like XIRR or CAGR. These terms even stump investors who have been investing for some time but suddenly check their statement one fine day. If you are one such person, you will obviously wonder what CAGR is or XIRR.
For the more curious, how to calculate CAGR or XIRR could be on their minds.
Let us try to decode these terms and understand their importance.
What is CAGR?
CAGR stands for Compounded Annual Growth Rate. It is one of the popular ways to calculate long term growth. In the context of investments, CAGR is used to calculate long term returns when you are purely looking for the growth between two distinct points over a certain period. It tells you the annualized growth of your investment.
For instance, 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, you need to apply the CAGR calculation to understand the annual return. In this case, it will be 25.99%.
How to Calculate CAGR?
To calculate the annualized growth over a period, you will have to use the formula:
CAGR = [(End Value/Starting Value)^1/t] – 1, where t = time in years
In the above example, our starting value is Rs 10,000, our end value is Rs 20,000 and time in years is 3. Accordingly, 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. Simply put, it is helpful to calculate returns on investment when there are multiple inflows or outflows in a portfolio. As most investors invest in mutual funds through SIPs, XIRR can be a helpful formula to calculate the average annualized return on the entire portfolio.
How is XIRR Calculated?
Let us understand it through an extension of the previous example. Suppose you started investing Rs 10,000 every year for three years and are looking at the final amount of Rs 60,000 at the end of 5 years.
In that case, it will be challenging to arrive at the annualized return for each investment and then a combined value. So instead, you use the XIRR function or formula in a spreadsheet to do this calculation.
In other words, your first instalment had 5 years to grow, the second instalment had 4 years, and the third instalment only had 3 years to grow. So if you look at the final amount of Rs 60,000, you could feel that your investment has doubled, or the absolute return on your investment is 100%, which is also true.
However, that doesn’t consider the time variations.
Now, suppose you use the XIRR function in spreadsheets or use an XIRR calculator available online. In that case, you will realize that the XIRR or the annualized average return on your investments is 18.61%.
Difference between XIRR and CAGR
|Measures the average rate earned by every cash flow invested during the period||Measures the compound growth rate|
|Considers multiple cash flows||Doesn’t consider multiple cash flows|
|Annualized Return||Absolute Return|
|Applicable for all types of cash flows||Suitable for long-term lump-sum investment return calculations|
It is important for investors to know certain basics like the difference between XIRR and CAGR, or the importance of such metrics in their investment journey. You can also invest in modern investment portfolios called WealthBaskets which are curated by top SEBI registered Advisors.
Staying abreast of the developments in your portfolio and understanding all the nuances goes a long way in investment success.
While CAGR is used to calculate returns only between two points of time, XIRR is used to calculate returns even in situations where there are more than one credit and debit in the entire chain of transactions, or timeline of investments.
Accordingly, while CAGR can help you understand the annualized return on a savings bank deposit over a few years, XIRR will be needed to calculate the returns from a mutual fund Systematic Investment Plan, or Recurring Deposit.
A CAGR return can be termed good for any portfolio only based on some other underlying facts, like the risk appetite of an investor and the financial product used for investments. For instance, with inflation around 6% and interest rates also around the same level, a CAGR of 6% from fixed deposits can be considered a good CAGR.
This is for a conservative investor who does not want to take major risks. A good CAGR for an aggressive investor investing in high-risk products like stocks, on the other hand, will be upwards of 10% or 15%.
Many investors are keen to understand what is CAGR in stocks. The CAGR calculation method can be used to calculate the annualized return on your stock investments over a period of time.
However, it is important to note that CAGR calculation is applicable when you are calculating returns on a single product or stock in a time period. If there have been multiple investments or withdrawals in a portfolio, it is better to use the XIRR calculation.
The Internal Rate of Return (IRR) calculated using the XIRR function in Excel and CAGR are very different calculation formulas suitable for different types of growth and investment patterns. If you have invested a lump-sum in a single product or stock and want to calculate the growth rate after, say, 2 years or 5 years, or 7.5 years, CAGR will be better for you.
However, if you have bought some shares from time to time over many years or months, or have been investing in mutual funds through a systematic investment plan, then using the XIRR is a better choice.