Before understanding the concept of XIRR (Extended Internal Rate of Return), you should know what is the CAGR (Compound Annual Growth Rate).
Both of them measure the annualized rate of return on investment. However, they are used in different contexts.
CAGR vs XIRR
Compound Annual Growth Rate represents the average annual growth rate of an investment over a specified period.
Imagine you invested your money in a mutual fund. If you want to know how much it has grown or declined each year, you can use CAGR.
CAGR calculates how much your investment has changed each year. But you should assume that it grew or declined steadily throughout the entire period. By finding out the CAGR, you get a straightforward view of your return.
But, XIRR is different. It is a method that calculates the return on a mutual fund when you invest money at different points in time.
Now, imagine you were investing in a mutual fund through SIP for one year. During this time, you have made multiple investments on different dates. So you could purchase different units of the mutual fund at different prices.
To calculate your actual return, you need to consider the timing and amounts of each investment. This is where XIRR comes in.
XIRR takes into account the various amounts of money you have invested at different times. It analyzes how much your investments are worth at present.
Importance of Extended Internal Rate of Return
Let’s see the difference between CAGR and XIRR with an example:
Suppose you made the following investments in a mutual fund:
- Initial investment: Rs. 10,000 on January 1, 2018
- Additional investment: Rs. 5,000 on June 30, 2019
- Additional investment: Rs. 3,000 on September 15, 2020
- Withdrawal: Rs. 2,000 on December 31, 2022
If you calculate the CAGR, it would be 18.92%.
To calculate XIRR, we consider both the investment and withdrawal cash flows and their respective dates.
Using spreadsheet software, we can find that the XIRR is approximately 20.02%.
So it is clear that XIRR is a more accurate measure of investment performance when cash flows are irregular.
XIRR helps you to understand the actual return of your SIPs. Therefore it provides a more accurate measure of your investment performance.
It is a valuable tool for assessing the success of your investment strategy. By using XIRR, you can get a clear picture of your financial status.
