Compound Annual Growth Rate (CAGR) and Extended Internal Rate of Return (XIRR) are the most confusing and interchangeably used terms nowadays and many investors do not understand which one to use, many new brokerage houses now started showing the returns in XIRR then CAGR, let’s try to understand them better.
Compound Annual Growth Rate (CAGR): CAGR is a representational figure, not a true average of any investments, didn’t understand 🙂 let’s break down with an example:
While calculating CAGR it’s assumed the returns/profit gets reinvested at the same rate of return, I am sure a lot of us are having many insurance policies which get sold to us where we might have paid lump sum money and after few years we get the lump sum back and the company offers the insurance in the middle.
Let’s say person A purchase a policy where he paid a lump sum of 1 CR and at the end of 20 years he gets a lump-sum return of 8 CR.
CAGR would be in case would be: ((Future Value / Present Value)^(1/Time)-1)
In this case FV is 800000 and PV is 200000, time is 20 years.
=((800000/200000)^(1/20)-1) = 7.18%
Did you notice in CAGR the inflow and outflow happen only once, but what if we have multiple inflows (just like Systematic Investment Plan (SIP)) or multiple outflows then CAGR would not be the correct way of calculating the returns.
Extended Internal Rate of Return (XIRR): First of all many people gets confused between IRR and XIRR.
The main difference between Excel XIRR and IRR functions is: IRR assumes that all the periods in a series of cash flows are equal. You use this function to find the internal rate of return for periodic cash flows such as monthly, quarterly or annual. XIRR allows you to assign a date to each individual cash flow.
In this post, lets discuss about XIRR with the example in Excel:
Mr X purchased got the shares of ICICI PRU in the IPO at a certain price and after that, he made a couple of purchase (cash inflow) and got dividends (cash outflow) also from the company over time.
XIRR forumula would be in this case =XIRR(cashflow_amount,cashflow_dates)
=XIRR(G2:G15,B2:B15) = 11.78%
Did you notice in XIRR the inflow/outflow happen at the irregular interval and multiple times, dividends are considered as cash flow out which goes into your bank account, but if you reinvest those then you can remove them from your calculations.
To define in simple terms: Your returns are based on how much you put in and when. And how much you take out and when. And always, the last entry assumes you take out everything today, to give you the return picture.
The best advice here would be that you can maintain your own portfolio with the help of excel and choose between XIRR or CAGR.
Create a excel sheet (google sheet will suffice) what ever investments you making in different instruments put the total amount and put the current portfolio value.
Over time this would give you the opportunity to understand how your portfolio and investments are doing and you can take better decisions to invest or redeem.
Let me know in comments section if you have any doubt, will try to answer.