Getting into investing we’re bombarded with different kinds of financial terms which we probably won’t have any idea about, CAGR and XIRR are a few of those terms we hear quite a lot but are not sure about what they mean and how we’d use it, let’s figure that out.
CAGR
CAGR stands for Compound Annual Growth Rate. It is a measure used to calculate the mean annual growth rate of an investment over a specified time period longer than one year. It represents one of the most accurate ways to calculate and determine returns for anything that can rise or fall in value over time. Investors often use CAGR to compare the historical performance of one investment with another.
It assumes that the investment grows at a consistent rate each year, which simplifies the comparison of the performance of different stocks or a stock against a market index. This is particularly useful for investors who want to evaluate the growth of a single lump sum investment over time without the complexity of additional contributions or withdrawals.
XIRR
XIRR stands for Extended Internal Rate of Return. It is a more advanced measure that calculates the internal rate of return for a series of cash flows that may not be periodic. XIRR is used in financial analysis to assess the profitability of investments with irregular cash flows, such as mutual funds with dividends reinvested at different times.
Know: Compounding Effect of Dividend Re-investing
XIRR is useful especially when investments are made through Systematic Investment Plans (SIPs) or there are multiple cash flows at irregular intervals. XIRR takes into account the timing and amount of each cash flow, providing a more accurate and personalized rate of return for the investor.
Conclusion:
To wrap things up, CAGR is ideal for stocks due to its simplicity and effectiveness in comparing the performance of single lump sum investments over time. Meanwhile, XIRR is better suited for mutual funds because it accurately reflects the performance of investments with multiple, irregular cash flows, such as those seen in SIPs. Each method caters to the unique characteristics of the investment type it is applied to, ensuring that investors have a clear picture of their investment’s performance.
