One of the questions you have “What is XIRR?”, if you’re like most investors and spending time looking at your portfolio. The other variation is like “What is Return on Invested Capital? “ If you’re anything like us, then you’ll struggle to get a clear picture of what XIRR means and why it matters. Let’s take a look at why this number is so important for investing, how to calculate it, and what insights we can get from it.
What is Return on Investment?
To begin with let’s understand this – What do we mean by Return on Investment? For those who aren’t familiar with it, we’ll take a moment to explain how it works. Return on Investment (ROI) is a calculation that shows how much (interest or profit) have you earned over you investment. When calculated in percentage term, it’s a way of measuring the effectiveness of an investment. The formula for ROI is ‘R’ divided by the ‘Amount you Invest’. Let’s take a look at an example to better understand what we’re talking about. We have Rs1000, and we invest this Rs1000 into an Investment that earns us Rs 100 as profit or interest. What is our ROI? We get Rs10 back for every Rs 100 we put in, right? This means we earn 10% on the amount invested.
What is CAGR then?
CAGR or Compounded Annualized Growth Rate is ROI measured over one year. Continuing with same example, you invest an amount of Rs 1000 for six months. In these six months you earn a profit of Rs 100, which is 10% of the total investment. So, your ROI is 10%. But in this case the investment is for a period of only six months. 10% returns are for six months. So, what would be the returns for 12 months? About 20%, right?
In this example, 20% is CAGR. When the returns are calculated on annual basis they are known as CAGR. This is required as other wise you will not be able to compare an investment done for 6 months with an investment done for 8 months.
Continuing with our example, if Rs 1000 are invested for a period of 8 months and if it earns returns of Rs 100, then the CAGR is 15%. But since in earlier case the amount was invested just for 6 months, though the absolute returns remain same as Rs 100 (10%), the CAGR works out to be 20%.
So CAGR is required for calculating annualized or yearly returns of an investment.
Mathematical formula for CAGR is
Vfinal is Final value of amount invested
Vbegin is amount invested at the beginning
t is time
Excel Function for Calculating CAGR is “Rate”, use =rate() and use the inputs as suggested
What is XIRR & why it is Important?
XIRR is required when- in one year you make many investments of different amounts. And you wish to calculate annualized or yearly returns of this total investment.
For example, you invest as follows
1st Jan – Rs 1000
15th March – Rs 1500
20th June – Rs 2000
Total investment you make is Rs 4500. But this is done on different dates. Only first investment of Rs 1000 will complete one year on 31st Dec. But remaining investments done on 15th March and 20th June are not completing one year on 31st Dec. In this case if you wish to calculate annualize returns on Rs 4500 as on 31st Dec, you will have to use XIRR function.
You earn, say total returns of Rs 300 for the year on all these investments, then what are the annualized returns on Rs 4500? In this case you cannot calculate it with CAGR formula as CAGR takes into consideration only one investment and calculates yearly equivalent of returns.
Here you will have to use the formula for XIRR.
Mathematical formula for XIRR is
N – transactions
Pi is payment number i,
d1 is the first ate of the investment,
di is the date of transaction number i
r is the interest rate applied.
However using mathematical formula is complicated.
You can use Excel Function for XIRR, =XIRR(), use the parameters as suggested by excel.
Where in real life can we use XIRR?
In all real-life investments XIRR is required. This is because you will not invest only one amount during the year. You will keep on investing different sums as and when the same is available to you. In this case XIRR is important for you to calculate performance of your investment. You can also compare the One Set of investment with Second Set of Investment and judge its performance.
Return on investment is a very important metric for investors to understand. It can help you identify which investments have the most promise and where you should be putting your money. In fact, it can even help you spot situations where you are wasting your time. If you’re interested in learning more about investing and what investing strategies work best, then you’ll definitely want to learn more about XIRR and how to calculate it.
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