XIRR vs CAGR: Which One Is Better To Choose?

XIRR vs CAGR: The ideal scenario would be for you to look at the historical performance of all the schemes you wish to invest in before you begin investing in mutual funds. You should choose the method that best suits you as there are various ways to compute prior returns.

For example, the two most popular metrics used to compute the returns on various investment products, including mutual fund returns, are XIRR and CAGR.

The majority of investors are perplexed about which metric to choose. Why, in the first place, should one evaluate their mutual fund investment’s return on investment? To determine which approach is the most appropriate for calculating mutual fund returns, we must thoroughly examine XIRR and CAGR.

What is XIRR?

Extended internal rate of return is abbreviated as XIRR. When cash flows occur at irregular intervals, a method is employed to determine the annualised return on investment.

The yearly rate of return is computed by taking into account all cash inflows and withdrawals, as well as the dates on which they occur. XIRR is a more accurate strategy for investments with irregular cash flows since it takes into account the timing and volume of each cash flow.

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What is CAGR?

The annualised return on investment is determined using the CAGR method, which stands for compound annual growth rate, when cash flows occur at regular intervals.

It determines the average rate of return over a certain period by assuming a constant rate of growth. CAGR is a popular measurement for long-term investments like mutual funds and is useful for determining how quickly an investment grows over time.

XIRR vs CAGR

When evaluating mutual funds with erratic cash flows, XIRR is frequently utilised. When an investor makes extra deposits or withdrawals at various times in time, this can be the situation.

XIRR provides a more realistic representation of the annualised return by accounting for the time and magnitude of each cash flow. It is helpful for comparing returns of funds with various investment patterns since it takes into account the compounding effect of investing or withdrawing money at various times.

Contrarily, CAGR is frequently utilised when assessing mutual funds with predictable cash flows. It is perfect for comparing funds that have a regular investing pattern since it implies a constant rate of growth over a given time period. CAGR is a useful tool for long-term investment analysis since it offers a condensed measurement of the average yearly return over a given time period.

While CAGR can be used to assess returns from lump-sum investments in mutual funds, it is advised to utilise XIRR for returns from periodic (non-lump-sum) contributions like SIP, according to Dev Ashish, founder of StableInvestor and a SEBI certified investment advisor. Consider investing a lump sum of Rs. 1 lakh in 2017. The value of this increases to 2 lakh in 2022 after 5 years. CAGR is used in this instance to determine the returns on lump-sum investments. This equals a CAGR of 14.87%.

The founder of Nishkaera Financial Advisory and Wealth Management, Mukesh Vijayvergia, echoes these ideas.

According to Vijayvergia, “While CAGR indicates the annualised compounded return on investment for a specific time, assuming that earnings are reinvested, XIRR measures the average return obtained by the investor after factoring in periodic cash flows separately within the specified period.

XIRR vs CAGR: Which one should you choose?

It’s crucial to pick a method for computing mutual fund returns that works with the fund’s investment strategy and cash flow behaviour. The preferred strategy is XIRR if the fund experiences irregular cash flows, such as extra investments or withdrawals made at different times. By taking into account the time and magnitude of each cash flow, it provides a more precise measurement of the annualised return.

On the other hand, CAGR is the preferable strategy if the fund has consistent growth and regular cash flows. It is appropriate for long-term investment research since it provides a condensed assessment of the average annual return over a given time period.

In conclusion, although both XIRR and CAGR are crucial tools for estimating mutual fund returns, their functions are different. While CAGR is appropriate for assets with regular cash flows, XIRR is good for those with irregular cash flows. Investors may make smarter selections and assess the returns on their mutual funds by knowing the advantages and disadvantages of each method.