CAGR: Best for one-time investments
Suppose you invested ₹1 lakh in a mutual fund scheme. You didn’t invest any additional amount. You did not withdraw any amount either. After five years, your investment has grown to ₹1.8 lakh.
You want to find out one thing now: What is the annual growth rate of my investment? This is precisely what CAGR helps us find out.
It transforms your entire investment experience into one yearly growth percentage, which makes comparing investments easy. It does not matter whether the market has risen in one year and fallen the next year. All CAGR cares about is the starting point of your investment and the endpoint.
Imagine it as a movie trailer. This provides you with the end highlights, but not everything that happens in between. This is why CAGR is an efficient method for a single investment and single redemption.
Common examples are:
- Mutual funds invested as a lump sum
- Stocks bought in one go
- Fixed deposits
- Bonds
- ETF purchases with a single purchase
Simple investment. Simple return metric.
Then why isn't everyone using CAGR?
Most individuals do not make their investment only once. They make investments through SIP. They raise the amount of their SIP following a hike in salary. Sometimes, they even make additional lump sum investments. Sometimes they stop investing for some months.
Here is the difficult part. Each investment comes on a different date to the market. This implies that each rupee receives a different timeframe to mature. However, the CAGR method assumes that the whole investment began at the same date.
That's why it doesn't always present the full picture.
XIRR: Built for the way most people invest
Think about investing ₹10,000 each month through the SIP route. The first instalment of January has seen more days than the December instalment in the market.
Would both give the same amount of returns? No way! It's for this reason that XIRR is required. XIRR stands for Extended Internal Rate of Return, which takes into consideration each investment along with its date of investment.
Rather than treating your whole portfolio as a single investment, XIRR focuses on the individual cash flows. In other words, XIRR keeps track of every single rupee you've invested along with the date of investing.
That's why it is a more accurate method to calculate SIP returns. If you have different investments in your portfolio, then XIRR generally calculates your return more accurately than CAGR.
XIRR vs CAGR: What's the real difference?
At first look, both values seem similar. They are represented by annual percentages. However, they have entirely different uses.
This is the simplest explanation of the XIRR vs CAGR comparison: CAGR talks about one investment. XIRR gives you the story of your whole investing experience.
A simple example
Suppose Rahul invested Rs. 5 lakhs in mutual funds. Rahul does not invest any further amount. After five years, his total investment value becomes ₹9 lakh. There was a single investment, and hence CAGR can be used to determine his annual returns.
Now meet Aisha. Instead of making a lump sum investment, she makes a ₹10,000 SIP each month in the same fund. Some instalments remain invested for five years. Some instalments remain invested for just a few months. In this case, if the CAGR assumes that all SIP instalments were made on the same date, the return calculated will not be accurate.
XIRR manages to overcome this challenge since it takes into account the timing of all investments.
This is the reason why the same mutual fund shows different return rates to different people.
When should you use CAGR and XIRR?
Choosing the right metric is simpler than it looks.
Consider using CAGR when you:
- Invest once.
- Do not deposit or withdraw any funds.
- Need to compare the relative long-term success of various investments.
Consider using XIRR when you:
- Invest using SIPs.
- Make further investments.
- Withdraw some funds at intervals.
- Multiple cash flows in your investment mix.
A simple thumb rule to keep in mind?
One investment = CAGR.
Multiple investments = XIRR.
Can XIRR and CAGR ever be the same?
Yes. In case there is only one investment and one withdrawal from the portfolio, both will provide almost identical returns.
The difference arises when there is some cash inflow or outflow during the holding period of the investment. The more cash flows, the more relevant XIRR becomes.
Common mistakes investors make
Even with the right measure for return, just a few minor errors can lead you to the wrong conclusion. Here is a list of mistakes investors often make.
Neglecting partial redemptions
A small withdrawal can affect your actual returns. This should always be taken into account when evaluating performance.
Comparing different timeframes
The one-year return and five-year annual return are two different things. Try comparing investments within the same timeframe.
Judging solely on the basis of return
Percentage of return doesn't always make an investment good. Risk involved and purpose of investment should be considered as well.
Checking returns too often
Short-term market fluctuations can lead you to misleading returns. Your investments need some time to deliver.
Relying on one number
XIRR and CAGR measure returns, but do not explain the risk, consistency, and strategies of earning that return.
Final thoughts
The comparison between XIRR vs CAGR can be made easy when one knows what each of these measurements represents.
CAGR clearly shows the growth rate on an annual basis for a single-time investment. XIRR, on the other hand, takes into account all investments and their timings, which makes it more suitable for SIPs.
Next time you review your portfolio performance, do not just check for the percentage. Start by finding out how the investments were made first. Having found out the answer to this question, deciding whether to use CAGR or XIRR gets easy.
