CAGR | IRR | XIRR ?
Return on your investment!
How do you measure your investment returns?
If you have paused on this page, it means you have either made some investments already or intend to make some in the future.
Either ways, this article will help you to clear all your doubts on measuring the returns your investment gives, once and for all!
So, before we deep dive, lets understand the concept of ‘investment’ itself.
Investment
In terms of finance, we put our money into an asset (financial/physical), to make more money out of it.
Return on Investment (ROI) is the terminology we generally use to measure how much more money we will make/have made on that invested money.
How do people invest?
Different people have different earning capacity, different income levels and different mindset. And hence, there is no one set time, frequency or amount in the finance industry that people should follow to invest their money. Yes, there are many products in the market, each of which define a standard investment structure (which may be same or different to another)
Different ways of investment
A fixed deposit requires a sum of money to be deposited in a single time. This type of investment is called as Lumpsum Payment.
While A Recurring deposit requires a fixed sum of money to be deposited at regular intervals (mostly on a monthly basis). This type of investment is called as Regular Payment, where both the amount and the interval is fixed.
For someone who receives a performance bonus every year, say in the month of January, chooses to invest that amount in a particular mutual fund scheme. Note: Since its a performance bonus, its a variable amount, i.e. it will not be same every year. Lets call this type of payment as Irregular payments at regular intervals. Here, the payment intervals remains fixed but the amount varies.
There could also be people who wish to tap the opportunities and invest when they think/feel the time is right or they are in a profession where income itself is not a fixed amount or at fixed intervals like freelancers! These type of payments are called as Irregular Payments. Here, neither the investment amount is fixed, nor the payment intervals.
Now, we know that money can be invested in different ways and by ways I mean the amount and the interval!
To make computations easier for people, there isn’t just one method to measure the returns on all of these investment ways.
Type of Returns
Holding Period Returns
Lets say you made an investment 2 years ago for 10000 bucks and today you are selling it as 15000 bucks. How much % of gains have you made?
To find this, you would do: (15000–10000)/10000, which is 0.5. To put it into %, you multiply 0.5 by 100, so that 50% gain!
The gain you just calculated is called as Holding Period Return (hpr)
Did you notice that hpr doesn't take into consideration the time for which you held your investment, it only needs the initial invested amount and the final selling amount to calculate your gains!
The hpr is also called as the absolute return.
Do you think hpr is a good enough measure to help you make financial decisions?
Most likely not!
The reason being that as humans, we are psychologically inclined towards measuring growth on yearly basis. Be it a hike in your job or a new resolution at the start of the year.
Same is the case when you think about the growth on your investment.
In finance, we call it the annualized returns or the annualized growth rate, which means how has our investment performed year on year basis
We will learn about different ways to measure the annualized returns below.
Annualized Returns
Remember, the lumpsum payment and the recurring deposit ?
To calculate the year on year growth for such investments, we use CAGR.
CAGR stands for Compounded Annual Growth Rate. Compounding is when you earn interest on interest. i.e. your principal increases every year by the amount of interest earned on it .
We all have come across the formula, A = P ( 1 + R ) ^ N, where
P = Principal amount that is invested
R = Growth Rate, the rate at which the principal will grow year on year.
N = Number of years for which the principal will be invested.
As you see, N is the number of years down which investment is held for.
CAGR, considers the time period as well. CAGR is not limited to lumpsum investment, it can be used to calculate the returns on a periodic/regular payment as well.
Now, what if instead of making a lumpsum payment or fixed payment every month/ year, a person wants to make irregular payments at regular intervals.
In that case, what we use is IRR ( Internal rate of return).
Note: IRR is a concept of MS Excel, but is now widely used in finance as well.
IRR takes into account a series of unequal cashflows, with each cashflow separated by a fixed interval period. So, in case of IRR, time interval is fixed, the amount can change.
However, a person may want to deposit these unequal amounts at random intervals(i.e. no fixed frequency), in that case we use XIRR (Extended Internal Rate of Returns). It is again an MS Excel concept widely used in Finance.
XIRR calculation takes into account dates (of payment) and the payment amount for each date.
So, XIRR is used for unequal payments at unequal Intervals or what we call Irregular Payments.
Note: XIRR can be used for equal intervals and equal payments as well, you will just have to specify the dates and amount.
XIRR is used to calculate the returns on your SIP investments.
This concludes our article on the types of returns on our investment. Below is a quick reference guide for you 🙂
If you are interested in the working of each of these, do comment and I will share it in the next article!
Happy Reading!
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