What is XIRR
XIRR, or Extended Internal Rate of Return, is a financial metric used to calculate the annualized return on investments where cash flows occur at irregular intervals. It is particularly useful for evaluating the performance of investments such as mutual funds, where contributions and withdrawals happen over time. XIRR takes into account the exact dates of each cash flow, providing a more accurate picture of investment returns.
What is CAGR
CAGR, or Compound Annual Growth Rate, measures the mean annual growth rate of an investment over a specified period longer than one year. It assumes that the investment grows at a steady rate, compounding annually. CAGR is a widely used metric for comparing the growth rates of different investments, as it simplifies the complexities of variable growth into a single, consistent annual rate.
What is the Difference Between XIRR and CAGR?
| Parameter | CAGR | XIRR |
| Assumption | Assumes a steady, annual growth rate. | Accounts for the actual timing of each investment and withdrawal. |
| Best For | Investments with regular, consistent contributions. | Investments with irregular contributions and withdrawals. |
| Calculations | Simplified formula that assumes growth happens smoothly every year. | Uses a more complex method, often requiring financial software or spreadsheet tools to get an accurate annualized return. |
Difference Between their Calculation?
- CAGR Calculation:
CAGR = ( Ending Value/Beginning Value)^1/n - 1
Where n is the number of years.
- XIRR Calculation:
XIRR requires the use of financial software or a spreadsheet tool like Excel, which iteratively solves for the rate that sets the net present value of cash flows to zero.
Practical Examples of CAGR and XIRR
- CAGR Example: If you invest ₹10,000 and it grows to ₹15,000 over 3 years, the CAGR would be:
CAGR = ( Ending Value/Beginning Value)^1/n - 1
(15000/10000)^⅓ - 1 = 0.145 or 14.5%
- XIRR Example: If you invest ₹10,000 initially, add ₹5,000 after 6 months, and the total value grows to ₹18,000 after 1 year, XIRR would consider the exact dates of these investments to calculate the annualized return
Comparing Advantages and Disadvantages
Advantages of XIRR
- Accurately reflects the impact of irregular cash flows.
- Provides a true annualized return, accounting for all investment timings.
Disadvantages of XIRR
- Requires more complex calculations.
- Sensitive to the timing of cash flows, which can lead to variability in results.
Advantages of CAGR
- Simple to calculate and understand.
- Useful for comparing the performance of different investments over the same period.
Disadvantages of CAGR
- Assumes a constant growth rate, which may not be realistic.
- Does not account for the timing of cash flows.
Choosing Between CAGR and XIRR for SIP Investments
For Systematic Investment Plans (SIPs), where investments occur at regular intervals, XIRR is generally more appropriate as it accurately accounts for the timing of each investment. CAGR might oversimplify the returns by assuming consistent growth, which is rarely the case in SIPs.
Choosing the Right Metric
Situations Where CAGR is More Appropriate:
- When evaluating investments with consistent, periodic cash flows.
- For comparing the growth rates of different investments over the same period.
Situations Where XIRR is More Appropriate:
- When dealing with investments that have irregular cash flows.
- For a more precise measure of annualized returns, considering the exact dates of cash flows.