CAGR vs XIRR: What’s the Difference and Why Does It Matter?

When you’re trying to figure out how well your investments are doing, you might come across terms like CAGR and XIRR. CAGR stands for Compound Annual Growth Rate. It gives you an average yearly growth rate, assuming your investment grows at the same rate every year. This makes it easy to compare how different investments are performing over the same time period. However, CAGR doesn’t consider if you added or withdrew money at different times, which can be a big drawback.

On the other hand, XIRR, or Extended Internal Rate of Return, takes into account the exact dates when you put money in or took money out. This makes XIRR more accurate for investments where you don’t just put in a lump sum and leave it alone. It’s especially useful for things like retirement accounts or any investment where you make multiple deposits and withdrawals. Knowing when to use CAGR or XIRR can help you get a better understanding of how your investments are really performing.

Which metric is better for tracking SIP investments: CAGR or XIRR?

For tracking SIP (Systematic Investment Plan) investments, XIRR (Extended Internal Rate of Return) is generally the better metric to use. Here’s why:

  1. Accounts for Irregular Cash Flows: SIP investments involve regular contributions at different times, which means the cash flows are not uniform. XIRR takes into account the exact dates and amounts of these contributions, providing a more accurate measure of your investment performance.
  2. Realistic Performance Measure: Since XIRR considers the timing of each cash flow, it gives you a realistic picture of how your SIP is growing over time. This is particularly useful for assessing the true return on your investment, as opposed to an average rate that assumes uniform growth.

XIRR is the preferred choice for tracking SIP investments because it handles the complexities of periodic investments more effectively than CAGR.