CAGR v/s IRR

Of course!  The most important measure of success as an invester is the rate of return. But what exactly does this mean? And how is it calculated?

There is no greater pleasure than to flaunt your rate of return. Assuming that it is something to be proud of. But more impoertatly, it is important that one is aware of the rate of return so that one can judge the success of the investment process. So how does one measure the rate of return of an investment? Often, many people use absolute return as a measure. Nothing can be as risky as using absolute returns of an investment. Absolute returns refer to the increase in the value of an investment without considering for how long the money has remained investment. So what is the right way to measure the rate of return?

CAGR and IRR are commonly used methods to measure the rate of return.

As the acronym suggests, the compounded annual growth rate (CAGR) indicates the compounded rate of return of an investment on an annual basis, considering the value of the investment at the start and the end of the period. CAGR is commonly used as a measure across several areas of business including to show the growth of a business or sales.  However, the validity of CAGR is limited to calculating the growth rate of an investment between a fixed start and end date. It is not a good indicator when investments are made at multiple points of time. This is where IRR comes in very useful. 

The calculation of CAGR is relatively straight forward. It can 3 inputs; the start value of an investment, the end value of an investment and the period for which the money remained invested.  While the CAGR calculation is an excellent indicator of returns, it becomes limited in use when the investments are made at multiple time periods eg. investments made via an SIP on a monthly basis. IRR is more flexible as it considers multiple cash flows and time periods. 

That begs the question. Which one is a better measure to understand the performance of an investment. Neither is categorically better. IRR is a better measure when investments are made at multiple points over time while CAGR is better suited while measuring the performacne of a lumpsum amount over a period of time.