Mutual funds in India could be a good investment option if you are looking to create wealth for short-term and long-term goals. Even though they are subject to market risks, there are ways to navigate through mutual fund investments to mitigate risks and make your decisions work for you.
Before you begin investing in such funds, it is essential to know about compounded annual growth rate (CAGR) and extended internal rate of return (XIRR), among other concepts, to implement a smart investment strategy.
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What is CAGR?
CAGR is the measurement of an investment’s growth rate over a period of time. It considers the effect of compounding. It is a valuable tool for analysing the compounded growth of mutual funds in India. When looking at different assets or investment tools, you need to evaluate the CAGR alongside a specific earning potential.
A financial advisor uses CAGR to analyse how your pooled asset portfolio performs compared to other plans, such as bank savings. The formula for calculating CAGR is:
CAGR = {EV/SV} 1/n – 1
Where:
EV = Investment’s ending value
SV = Investment’s starting value
n = Duration of investment (months, years, etc.)
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What is XIRR?
XIRR, conversely, is beneficial for portfolios where there are multiple investments at irregular intervals. Specifically, XIRR is suitable for uneven cash inflows and outflows. It derives your actual and current rate of return, thereby making it more reliable and convenient to use. You can calculate XIRR in an excel sheet using this simple formula:
=XIRR (Values, Dates, Guess)
Where:
- Value is transaction amounts, including investment and redemption
- The date is when the transaction happened
- Guess is approximate returns
How are Cagr and Xirr Different?
XIRR is appropriate for calculating the rate of return on the money you invest in mutual funds. CAGR is used to determine how a mutual fund performs on its own. While XIRR is suitable for portfolios with more than one investment spread across a period, CAGR is ideal for those where you must calculate only lump sum investments. Another difference between CAGR and XIRR is that the former does not consider multiple cash inflows while the latter does.
In some cases, investments are made over a long period of time at different intervals. In such a situation, a CAGR may not be appropriate to ascertain the profits. If you’re contributing through Systematic Investment Plans or lump sums or reclaiming through Systematic Withdrawal Plans or lump sums, XIRR is the correct way to measure your returns.
Using CAGR and XIRR to Take Investment Decisions
A financial advisor’s job is to determine investment returns and then choose an investment scheme for their clients. To assess the profitability of an investment, both parties must understand absolute returns, XIRR and CAGR. By understanding how these two factors are calculated, you can figure out which mutual fund investment would give you a decent return compared to bank deposits.