What Is The Difference between CAGR and XIRR?
Investments are all about creating and growing your wealth. The earning potential of an investment is what helps you determine whether to invest or not. The risk-return correlation is such that if you are looking for higher earnings you will have to take on more risks.
Mutual fund investments requires a thorough understanding of earnings potential. Let us understand the two key computations—Compounded Annual Growth Rate (CAGR) and Extended Internal Rate of Return (XIRR), to compare these options and accurately choose the right investment instrument.
What is Compounded Annual Growth Rate (CAGR)?
When you compare different funds or investment products, you must compare the CAGR to arrive at a more accurate earning potential. CAGR takes into consideration the investment tenure and thus provides a more accurate and comparable earnings percentage. The formula to calculate CAGR is:
- CAGR (%) = (Current or Maturity Value/Investment Value) ^ (1/investment tenure in years) – 1
Let us assume that we have two investment options; one wherein you earn INR 200 on an investment of INR 1,000 over 20 months and the other wherein you earn INR 100 on an investment of INR 1,000 over 10 months. Now in order to decide which option is the best, you must calculate the CAGR for both these options and then decide which one is a better investment option.
For the first option, you earn a CAGR of 11.54% calculated as (1200/1000) ^ (1/1.67) – 1 (20 months are equal to 1.67 years as 20 months/12 months = 1.67 years)
For option two, CAGR is 12.17% determined as (1100/1000) ^ (1/0.83) – 1 (10 month are equal to 0.83 years as 10 months/12 months = 0.83 years)
Having compared both the options, you can see that option two is earning better returns than option one. On the other hand, the absolute returns on the first option are higher than the second one. Nonetheless, the earning potential for the second option is greater as determined by the CAGR.
What is Extended Internal Rate of Return (XIRR)?
CAGR works most accurately when you make a one-time investment and the maturity amount keeps getting re-invested. However, what happens when you invest in mutual funds through a Systematic Investment Plan (SIP)? The earnings percentage for each tenure could be different and that is where the CAGR fails to provide accurate earnings percentage over the cumulative investment tenures.
The XIRR accounts for the multiple investments made into the same SIP over the investment tenure and treats them as separate investments.
Let us understand this better with an example. Assume that you have been investing INR 1,500 every month in an SIP for the past two years and the current value of the same is INR 40,000.
The CAGR on the above illustration would be at 5.41%. Using the formula (36000/40000) ^ (1/2) – 1.
However, this would be inaccurate as the different investment tenures are not accounted for herein. This simply assumes that the entire amount was invested at the beginning of the tenure, which is not the case. This is why you should know the XIRR as it accounts for the periodic investments.
If you want to invest a lump sum, calculating the CAGR for different options is beneficial. However, if you want to invest at different times, using XIRR to make an investment decision is more accurate.
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