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CAGR AND XIRR
What is CAGR?
The Compound Annual Growth Rate (CAGR) measures the mean annual growth rate of an investment over a period longer than one year. It represents the constant rate at which an investment would have grown if it had compounded at the same rate each year.
The CAGR Formula
CAGR is calculated with a simple formula:
- FV = Final Value
- IV = Initial Value
- n = Number of years
Limitations of CAGR
While useful, CAGR has its limitations:
- It's a hypothetical number: CAGR assumes a steady growth rate, which rarely happens in the real world. Investment returns are typically volatile.
- Doesn't account for risk: An investment with a high CAGR might also come with high volatility and risk, which this metric does not reflect.
- Ignores cash flows: The standard CAGR formula only considers the beginning and ending values, ignoring any additions or withdrawals made during the investment period. For that, XIRR is a better metric.
What is XIRR?
The Extended Internal Rate of Return (XIRR) calculates the annualized return for a series of cash flows occurring at irregular intervals. It is ideal for investments like SIPs in mutual funds, where you make multiple transactions over time.
CAGR vs. XIRR
- CAGR is best for lump-sum investments where you have a single starting and ending value.
- XIRR is superior when multiple transactions (investments or withdrawals) are made at different points in time. It provides a more accurate picture of your portfolio's performance by considering the timing of each cash flow.
Interpreting Your XIRR Result
The XIRR percentage is your actual annualized return.
- Positive XIRR: Indicates that your investment has generated a profit. The higher the number, the better the performance.
- Negative XIRR: Indicates that your investment is currently at a loss.
- Tip: For an accurate calculation, ensure your first cash flow is a negative number (investment/outflow) and the last cash flow (your final redemption value) is a positive number (inflow).