What is the difference between Annualised Return, CAGR, IRR & XIRR in personal finance? Why these calculations are important? Why mutual fund websites highlight their CAGR performance?
But the most important question would be, what is the use of these terms in Personal Finance? I am sure that if I do not provide this in the beginning itself, my readers would not read this article completely and would leave them midway.
Annualised Return, CAGR, IRR & XIRR – Where to Use
- AAR is useful when you have invested your money in Fixed Deposits (FD), National Savings Certificates (NSC) or Kisan Vikas Patras etc. This will exactly tell you the rate of annualised return in a span of 5-10 years.
- CAGR is useful when you have invested a lump sum amount of your money in stocks or mutual funds and value of your money is fluctuating every now and then.
- IRR is useful when you are investing your money at regular intervals or on a periodic basis like SIPs. The amount invested may vary but the time of investment is at regular intervals.
- XIRR is useful when you are investing at irregular intervals.
Simple Annualised Returns
If you have invested Rs. 10,000 and getting a simple interest rate of 1% per month, your money will grow to Rs. 11,200 after one year and you will get 12% simple annualised returns.
Average Simple Annualised Returns (ASAR)
If you have invested Rs. 10,000 for 5 years and your money grows to Rs. 20,000 after 5 years. Your average simple annualised return will be 20%. Let us see how:
• Average Simple Annualised Returns = (Final Value – Invested Value)/5*100
• Average Simple Annualised Returns = (20,000 – 10,000)/5*100 = 20%
• Average Annual Returns can also be calculated by arithmetic mean of returns in different years
Suppose you are investing (same amount) in different avenues every year:
2011 – 20%
2012 – 18%
2013 – 16%
2014 – 22%
2015 – 24%
AAR – (20+18+16+22+24)/5 = 20%
Compound Annual Growth Rate (CAGR)
Compound Annual Growth Rate or CAGR calculates the annual compound interest rates which you are getting on your investments. It also takes the final value and initial value of your investments. CAGR is normally used when there are wide fluctuations in your investments during a particular period of time. This happens mostly in cases of stock prices or equity mutual funds.
If you have invested Rs. 10,000 for 5 years and your money grows to Rs. 20,000 after 5 years. Your Compound Annual Growth Rate will be 14.87%.
CAGR Interest Rates = (Final Value/Initial Value)^(1/n)-1=(20,000/10,000)^(1/5)-1=14.87%
The difference between ASAR and CAGR is that ASAR calculations are on the basis of simple interest rates while CAGR calculations are on compound interest rates.
CAGR is normally shown on mutual fund websites to show the performance of their funds for more than 1 year period.
Internal Rate of Return (IRR)
IRR is calculated, when you are investing at regular intervals of time like in SIP investments in mutual funds, where you have a fixed date when the money is deducted from your account.
Suppose you are investing in Mutual Funds SIPs, this is the rate of return you will get on your investments.
Suppose you are investing Rs. 1,000 per year and value of your money in the 7th Year is Rs. 10,000. IRR will be 15%.
How to calculate IRR?
Go to Excel -> Go to Fx -> Financial Formulas -> IRR
Put the values – Your invested amount will be in negative – Any dividend received or final value will be in positive.
Internal Rate of Return for Irregular Cash Flow (XIRR)
XIRR is for irregular cash flows. This is important for people who are not investing on regular intervals.
There can be various reasons for investing at irregular intervals:
- I am a businessman, investing whenever I get excess cash
- I am a salaried person and have received my annual bonus
- I need to invest for my tax savings
How to calculate XIRR?
Go to Excel -> Go to Fx -> Financial Formulas -> XIRR
Put the values – Your invested amount will be in negative – Any dividend received or final value will be in positive – Use any guess value like .5, 1 etc
I hope this article will help to calculate the returns according to your investments. Do not be misled by the advisors who show you the CAGR returns, when you want to invest in SIPs or show you IRR when you are not investing at regular intervals.
Do share with your friends if you have understood the difference between Annualised Return, CAGR, IRR & XIRR.