A few days ago, I tried to cover an important metric for evaluating returns: CAGR. But one may wonder, that CAGR is used to evaluate returns over a period for lumpsum investments. In all likelihood, we don’t invest lumpsum amounts. More than often it is in the form of monthly investments a.k.a SIP. We invest in Systematic Investment Plans by in putting in a fixed/variable amount in a mutual fund at a fixed interval. So how do we calculate returns for an investment (stretched over a period of time) where there are multiple entry points. Enter: XIRR or Extended Internal Rate of Return.
XIRR vs CAGR
The best way to pick the correct metric for evaluating a return amongst CAGR and XIRR would be to gauge the number of entry and exit points.
So if you are entering an investment instrument once and exiting it once, CAGR would work perfectly fine. However, if you invest over a period of time in bursts, or you may also redeem/exit partially in that period, CAGR won’t help. Latter cases would need XIRR to evaluate the returns.
Let’s understand with the help of an example. Suppose you have invested in a mutual fund with Rs. 1000 as a monthly investment (for 1 year) starting from 5th January 2019. Now, your first installment is going to stay invested for 14 months. Second installment will be invested for 13 months and the final installment would be invested only for 1 month. So, it is fair to assume that returns these investments are making is not going to be the same.
So, if we were to calculate the absolute returns in this case, we would get a figure of 11.5%
Do you think that is the return you are making? Absolutely not!
How to Calculate XIRR:
A labor intensive way of doing it would be to calculate it for each 1,000 using a pen and paper. Convenient right?
So, thanks to excel which has ready formula for calculating XIRR (Office 2016 onwards). Simply type in =XIRR in the cell. It seeks two arguments from you:
A. The amount range (which includes redemption as well)
B. The date range
So for the above example, calculations would look something like this:
Using this, XIRR for this investment comes out to be 19.8%. And that is the return we are going to make.
There are a a few things you need to keep in mind for this formula to work:
- Date has to be in DD-MM-YYYY format. For some reason, other formats don’t work.
- All the outflows (from your PoV) should be in negative and accompanied by a minus(-) sign.
- All in the inflows (from your PoV) should be in positive (+).
The same method is also going to work for the following cases as well:
- If entry points are not uniform: In case you may not be able to invest for a couple of months every now and then.
- If amount is not consistent: You may invest a varied amount in SIPs depending on the situation. Especially if you are into business and don’t have a fixed income.
- If there are multiple payouts: You may redeem your amount partially to book profits or in case you need money.
XIRR is one of the key metrics when you are comparing performances of multiple mutual funds. Once again, don’t fall in the trap of absolute returns and be a smart investor. Hope this adds value to your life (literally)
Until Next Time..