Introduction
It is important to analyse investment performance to understand how your money is working for you. Compound Annual Growth Rate (CAGR) and Extended Internal Rate of Return (XIRR) are two common metrics that help you calculate investment returns. They are essential tools but have certain key differences. Learn about their distinct applications to pick the right metric for your requirements and make informed portfolio decisions.
What is XIRR?
Extended Internal Rate of Return, or XIRR, helps evaluate an investment’s rate of return based on its cash flows. It considers all cash outflows and inflows, including capital gains and dividends, over a specific period to determine the returns generated.
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XIRR differs from CAGR and other traditional metrics since it accounts for inconsistent cash flows and multiple periods. It is suitable for assessing investments with complex cash flow patterns. Portfolio investors can use XIRR to evaluate and distinguish how individual stocks perform within their portfolio. It helps in spotting shares that offset gains or cause losses.
Formula for XIRR
There is no straightforward algebraic formula for XIRR as it focuses on solving an equation iteratively. But if you’re using Microsoft Excel, Google Spreadsheet or any other spreadsheet software, you can enter the following function structure:
= XIRR (values, dates, [guess])
Where,
● ‘values’ refer to cash flows corresponding to a timeframe of incomes and payments
● ‘dates’ refers to the dates of cash flow payments
● [guess] is what you estimate XIRR to be
What is CAGR?
Compound Annual Growth Rate, or CAGR, is a vital financial metric for analysing investments. It measures an investment’s annual growth rate over a specific duration, assuming it has compounded over time. It differs from absolute return, which does not consider time and only measures the point-to-point return.
CAGR estimates the average annual return by accounting for the initial investment, final value, and time progressed. The financial metric is easy to understand and calculate. You can do it manually if you have the investment’s starting and ending value and the investment period. Many investors prefer CAGR because it allows comparisons of returns across diverse asset classes.
Formula for CAGR
The formula for calculating CAGR is:
CAGR = (Final Value/Initial Value)^(1/n) - 1
Where,
● ‘Final value’ refers to the investment’s ending value
● ‘Initial value’ refers to the investment’s starting value
● ‘n’ is the investment’s holding period
CAGR vs XIRR - key differences
Which is better between CAGR and XIRR?
The debate over CAGR vs XIRR is common because of the difference in their application, suitability, and efficiency. XIRR can accommodate different investment amounts and intervals. Thus, it is the ideal choice for evaluating SIPs. It calculates the return on each instalment accurately by adjusting to the investment’s inherent dynamism. On the other hand, while CAGR can simplify the returns, it does not consider the effects of periodic investments, thereby misleading judgments.
CAGR is a more suitable method of calculating returns for single investments. It also helps compare the growth rates of different assets or sectors over a specific period. You should prefer CAGR in cases where the priority is investment simplicity and broad overview.
XIRR is the right choice for the return calculation of investments with irregular cash flows. These include investments like angel investing or real estate. You can rely on XIRR to analyse the return of a portfolio with ongoing withdrawals and contributions. Moreover, XIRR is appropriate for analysing inconsistent income-generating assets like bonds or dividend stocks.
Conclusion
CAGR and XIRR are efficient tools for analysing investments. It is essential to consider the timeframe, cash flow patterns, and other minute details while analysing investments to make informed investment decisions. If you know when to use which one, you can select the right metric for your specific needs.
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