When evaluating mutual fund returns, CAGR (Compound Annual Growth Rate) and XIRR (Extended Internal Rate of Return) are two essential metrics. CAGR is best suited for lump sum investments, as it assumes a constant annual growth rate over a specific period. It provides a simplified view of returns but does not account for multiple cash flows. XIRR, on the other hand, is ideal for investments with irregular transactions, like SIPs or withdrawals. It considers both the timing and amount of each cash flow, offering a more accurate measure of actual returns. Understanding these differences helps investors make better financial decisions.
In this article, we delve into the differences between CAGR and XIRR, explain their significance and appropriate applications to empower your financial decision-making.
What is XIRR?
XIRR, or Extended Internal Rate of Return, is a more nuanced metric than its conventional counterpart, IRR. It caters to investments with multiple cash flows at irregular intervals, offering a comprehensive view of an investment's performance.
Particularly useful in real-world scenarios where investments and withdrawals occur at unpredictable times, XIRR provides a yearly rate of return that helps investors gauge the efficiency of their investments over time. Understanding XIRR is paramount for investors dealing with varying cash flows, ensuring they have a reliable metric for their financial analysis.
What is CAGR?
CAGR, or Compound Annual Growth Rate, serves as a key metric when it comes to investments, translating the cumulative returns of an investment into an annualised average. Unlike XIRR, CAGR assumes the investment grows at a steady rate over time, providing a smoothed estimate of return that does not account for fluctuations in capital inflow or outflow.
Ideal for comparing the growth rates of different investments over the same time period, CAGR narrows down the essence of an investment's growth trajectory into a single, comprehensible figure. For investors and analysts, understanding CAGR is crucial to evaluating and comparing the long-term performance of various investment avenues.
Difference between CAGR and XIRR
While both XIRR and CAGR offer insights into investment returns, their applications differ markedly due to the nature of the cash flows they accommodate. CAGR is best suited for investments with a single initial outlay followed by a period of growth, untouched by further contributions or withdrawals. On the other hand, XIRR steps in when the investment landscape comprises irregular cash flows, providing a nuanced perspective on returns.
The crux of their difference lies in their approach to timing and cash flow. CAGR overlooks the timing of investment movements, offering a broad-brush perspective. Whereas XIRR delves into the specifics, adjusting its calculations to the exact timing of cash flows, thus providing a more detailed view of investment performance.
XIRR vs CAGR: Key differences in a comparison table
Particulars |
XIRR |
CAGR |
Cash Flow |
Accommodates multiple, irregular flows |
Assumes a single initial investment |
Suitability |
Varied investment timelines |
Single, uniform investment period |
Precision |
High, adjusts to specific cash flows |
Lower; averages out investment growth |
Complexity |
Relatively high, requires detailed cash flow data |
Simpler; easier to calculate |
Application |
More versatile, suits complex investments |
Ideal for straightforward, steady growth investments |
Calculation |
Takes into account specific dates and cash flow amounts. |
Uses the initial and final investment values along with the time period. |
Timing of Investment Formula |
Factors in the precise timing of each investment or withdrawal. |
Assumes a single investment made at the beginning, with no further additions. |
Accuracy |
More precise for investments with irregular cash flows. |
May not fully capture performance variations in non-uniform investments. |
Investment Type |
Works well for investments with variable contributions, like SIPs. |
Ideal for lump-sum investments with no additional inflows. |
Rate of Return |
Provides a rate that accurately represents all cash flow timings. |
Reflects a steady annual growth rate, without accounting for cash flow variations. |
Formula and numeric example for CAGR
The formula to calculate the Compound Annual Growth Rate (CAGR) is:
| CAGR = (Final Value/Initial Value)^(1/n) - 1 |
- ‘Final Value’ represents the ending value of the investment.
- ‘Initial Value’ is the value of the investment at the start of the period.
- ‘n’ is the number of years over which the investment is held.
Assuming you invest Rs. 1,00,000 in a stock on January 1, 2020. By January 1, 2025, the value of this investment will grow to Rs. 1,61,051. To calculate the CAGR:
- CAGR = (Final Value / Initial Value)^(1/n) - 1
- CAGR = (1,61,051 / 1,00,000)^(1/5) - 1
- CAGR = (1.61051)^(0.2) - 1
- CAGR ≈ 0.1 or 10%
This calculation means the investment has grown at an annual rate of 10% over five years, assuming the reinvestment of earnings at the end of each year.
Formula and numeric example for XIRR
XIRR does not have a simple algebraic formula like CAGR since it involves solving an equation iteratively. However, when you are using spreadsheet software like Excel or Google Sheets, you can calculate XIRR using the following function structure:
| = XIRR (values, dates, [guess]) |
- ‘values’ refers to a series of cash flows that correspond to a schedule of payments (negative values) and incomes (positive values).
- ‘dates’ is a series of dates corresponding to the cash flow payments
- [guess] is your guess for what the XIRR might be; it's optional and usually not required because the software has a default.
For XIRR, consider an investment scenario with multiple cash flows. You invest in a mutual fund:
- On January 1, 2020: You invest Rs. 1,00,000 (a negative cash flow as this is an outlay).
- On January 1, 2022: You make an additional investment of Rs. 50,000.
- On December 31, 2024: The total value of your investment is Rs. 1,80,000 (a positive cash flow as this is a return).
To calculate XIRR in Excel, arrange your cash flows and corresponding dates and apply the XIRR function:
| Date | Amounts (Rs. ) |
| 1/1/2020 | -Rs. 100,000.00 |
| 1/1/2022 | -Rs. 50,000.00 |
| 12/31/2024 | Rs. 180,000.00 |
| XIRR | 4.28% |
This function will numerically calculate the rate within the spreadsheet. In this case, the XIRR is 4.28%.
XIRR vs CAGR: Pros and Cons
Factor |
XIRR |
CAGR |
Pros |
|
|
Cons |
|
|
Limitations or Assumptions associated with XIRR And CAGR
While XIRR and CAGR are valuable for assessing investment returns, they come with certain assumptions and limitations that investors should consider:
XIRR Limitations:
- Complexity: Calculating XIRR requires financial tools or software due to its reliance on multiple cash flows and dates.
- Input Sensitivity: Even small errors in transaction dates or amounts can significantly alter the result.
- Reinvestment Assumption: XIRR assumes that cash flows are reinvested at the same rate, which may not always be feasible.
CAGR Limitations:
- Overlooks Volatility: CAGR smooths returns, potentially masking short-term fluctuations or risks.
- Steady Growth Assumption: It assumes a constant growth rate, which may not reflect real-world market variations.
- Limited Data Consideration: CAGR only factors in the starting and ending values, ignoring interim cash flows.
Additionally, both methods assume reinvestment of returns and do not account for external factors like taxes, inflation, or transaction costs, which can impact actual returns.
CAGR vs XIRR for SIP: Which is better?
When it comes to Systematic Investment Plans (SIPs), the debate of CAGR vs XIRR gains prominence due to the periodic nature of investments. XIRR, with its capacity to accommodate varying investment intervals and amounts, emerges as the preferable metric for SIPs. It accurately reflects the return on each instalment, adapting to the investment's inherent dynamism. Conversely, CAGR might simplify the returns to a misleading extent, overlooking the nuances of periodic investments.
Situations where CAGR is the more appropriate method of calculating returns
For single lump-sum investments without additional contributions or withdrawals.
When comparing the growth rates of different sectors or assets over a uniform period.
In cases where investment simplicity and broad overview are prioritised.
Situations where XIRR is the more appropriate method of calculating returns
For investments with non-periodic cash flows, such as real estate or angel investing.
In analysing the return of a portfolio with ongoing contributions or withdrawals.
For evaluating irregular income-generating investments like dividend stocks or bonds.
Final thoughts on XIRR vs CAGR
Understanding the differences between XIRR and CAGR equips investors with the analytical tools necessary for nuanced investment assessment. While CAGR offers a straightforward, averaged-out perspective, XIRR delves into the intricacies of each cash movement, providing a tailored analysis. The choice between XIRR and CAGR depends on the investment's nature and the detail level required, emphasising the need for a context-driven approach in financial analysis.
