Investing in financial instruments is a popular way to beat inflation and grow your wealth over time. It is important to know about an investment’s past performance before investing in it, although the past performance of an investment does not guarantee future returns, but it can give you a fair idea of how much potential a particular investment tool has. there are a few key metrics that investors commonly use: XIRR, CAGR, and absolute returns. These metrics can help investors understand the performance of an investment over a specific period of time and make informed decisions about whether
CAGR also known as compound annual growth rate, is a measure of the average annual growth rate of an investment over a specified period of time taking into account the effect of compounding. It gives a clear picture of compounded returns earned by the investor annually on an investment that has experienced significant fluctuations in value over time. It is generally calculated for lump sump investment made.
How to calculate CAGR?
Here’s how to calculate CAGR:
Determine the beginning value of the investment. This could be the initial investment amount or the value of the investment at the beginning of the specified period.
Determine the ending value of the investment. This could be the current value of the investment or the value of the investment at the end of the specified period.
Determine the number of years in the investment period. This could be any length of time, such as 5 years, 10 years, or more.
Calculate the CAGR using the following formula:
CAGR = (Ending value / Beginning value) ^ (1 / Number of years) – 1
For example, let’s say you invested ₹100,000 in a stock 5 years ago, and it’s now worth ₹170,000. To calculate the CAGR, use the following formula:
CAGR = (₹170,000 / ₹100,000) ^ (1/5) – 1 = 11.20%
| year | Investment’s Value at the end of year | Year on year returns |
|---|---|---|
|
Year 1: 2017 |
₹95,000 |
-5.00% |
|
Year 2: 2018 |
₹115,000 |
21.05% |
|
Year:3 2019 |
₹135,000 |
17.34% |
|
Year:4 2020 |
₹160,000 |
18.51% |
|
Year:5 2021 |
₹170,000 |
6.25% |
What is XIRR?
XIRR also known as extended internal rate of return, is a more complex measure of investment performance that takes into account the timing and size of cash flows into and out of an investment. XIRR is often used to evaluate the performance of mutual funds or any other investment tool which typically have regular cash inflows and outflows. For example, returns earned on making SIP each month in a mutual fund for 5 years will be calculated using XIRR.
How to calculate XIRR?
Here’s how to calculate XIRR:
Determine the cash flows for the investment. This includes all cash inflows and outflows, including the initial investment and any subsequent investments or withdrawals.
Determine the dates of each cash flow. This includes the date of the initial investment, as well as the dates of any subsequent investments or withdrawals. All investment amounts are denoted in negative and the final amount is denoted as positive.
Input the cash flows and dates into a spreadsheet or financial calculator.
Use the XIRR function in Excel or a financial calculator to calculate the XIRR. The XIRR function calculates the rate of return that makes the present value of all cash inflows equal to the present value of all cash outflows.
Let’s take an example of an investment of ₹20,000 made each year for 5 consecutive years in a mutual fund. The current value of the investment is ₹160,000. The XIRR for this investment would be approximately 16.08%, which means that the investment earned an average annual rate of return of 16.08% over the investment period.
| DATE of investment | Investment amount |
|---|---|
|
Year 0: January 1, 2017 |
-₹20,000 (initial investment) |
|
Year 1: January 1, 2018
|
-₹20,000 (investment) |
|
Year 2: January 1, 2019
|
-₹20,000(investment) |
|
Year 3: January 1, 2020
|
-₹20,000(investment) |
|
Year 4: January 1, 2021
|
-₹20,000(investment) |
|
Year 5: January 1, 2022
|
₹160,000(current amount) |
Absolute Returns
Absolute returns refer to the actual or total returns earned on an investment over a given period of time, expressed as a percentage of the initial investment amount. Absolute returns are often used as a simple measure of the gain made in the investment.
For example, if the investment of ₹100,000 into a mutual fund becomes ₹160,000 in five years then the absolute return on the investment would be 60% (₹160,000 / ₹100,000 x 100%). This represents the actual profit made by the investor.
Words of Wisdom
“Making money is easy. It is. The difficult thing in life is not making it; it’s keeping it.” — John McAfee
Key Takeaways
- XIRR provides a more accurate measure of returns for investments for irregular cash flows.
- CAGR offers a standardized way to compare the past performance of investments over a time frame. It smoothens the impact of volatility and provides a single, consistent growth rate.
- Absolute returns give a clear picture of the actual monetary gain or loss on an investment.
- XIRR and CAGR are often used for investment analysis. Absolute returns are valuable for a quick assessment of overall portfolio performance.
Conclusion
Each of these metrics can be useful in evaluating the potential profitability of an investment. XIRR calculates the internal rate of return for investments with irregular cash flows that occur on specific dates. It takes into account the timing and size of each cash flow while CAGR measures the annual growth rate of an investment over a specified period. Absolute returns on the other hand are the total returns earned on an investment over a given period, expressed as a percentage of the initial investment amount.
Thank you for taking the time to read this blog post! I hope you found the information helpful and informative. If you have any thoughts or feedback, I’d love to hear from you in the comments section below. You can also follow me on social media to stay up to date with my latest posts and updates.
