A good investor compares different financial products based on their returns while investing their money. There are multiple metrics that can be used for this purpose and you might have encountered some of them.
A good investor compares different financial products based on their returns while investing their money. There are multiple metrics that can be used for this purpose and you might have encountered some of them.
Suresh invested ₹1,00,000 two years back. Now, the total value of his portfolio has risen to ₹1,50,000. According to his calculation, he made a profit of ₹50,000, and thus his portfolio has seen a growth of 50%. Witnessing the numbers, he was delighted. He used RoI to calculate his returns, and its formula is straightforward:
Suresh being a novice, committed the rookie mistake of using RoR. RoR doesn't consider the time it took to give that much profit. If he had a gain of ₹50,000 after the first year, his RoR would still be 50%. For this, we need a metric that will also consider the time period the money was invested.
CAGR Stands for "Compound Annual Growth Rate." CAGR is the rate of return (RoR) required for an investment to grow from its beginning to its ending, assuming the profits were reinvested at the end of each year during the lifespan of portfolio.
Let's get back to Suresh's portfolio. He invested ₹1,00,000 for two years and his final portfolio value is ₹1,50,000. Using the CAGR calculator, he got to know that his investment has a 22.47% return, which means that his money has grown 22.45% annually since he started investing.
Suresh made a one-time investment of ₹1,00,000. This type of investment is called lumpsum. Then there is systematic investment, where an investor can invest a fixed amount of money either on a weekly, monthly, quarterly, or yearly basis. This type of deposit plan is called Systematic Investment Plan or SIP. CAGR cannot be used for this type of investment as there are many cashflows distributed over varying periods of time. For this type of investment, we can either use Internal Rate of Return (IRR) or Extended Internal Rate of Return (XIRR). Both are similar, but XIRR is mainly preferred because it considers the cash flow date instead of the interval (week,month,etc. ) for calculation.
Suppose Suresh invested in a half-yearly SIP of ₹25,000 for 2 years in some financial product giving 12% annual returns. The total investment amounts to ₹1,00,000 over this period. After investing for two years, Suresh withdrew all the money including the interest earned on investment. The cashflows, and the duration for which money was invested, are shown in the table below.
| Date | Action | Amount | Invested Period |
|---|---|---|---|
| 1 January 2020 | Deposit | ₹25,000 | 2 Years |
| 1 July 2020 | Deposit | ₹25,000 | 1.5 Years |
| 1 January 2021 | Deposit | ₹25,000 | 1 Years |
| 1 July 2021 | Deposit | ₹25,000 | 0.5 Years |
| 1 January 2022 | Withdraw | ₹1,17,177.51 | - |
As there are multiple cashflows, we cannot use CAGR. The money was also invested for different duration, thus earning different interest amounts. In these cases, XIRR is used.
For Suresh investment, the XIRR comes out to be 13.3% .