Investment word of the day: Extended Internal Rate of Return — what is XIRR and why is it crucial for MF investors?

Anyone investing in various instruments, including a Systematic Investment Plan (SIP) or regular deposits in mutual funds, will need to consistently track returns to assess the performance of their investments and make informed decisions.

Tracking investments may seem straightforward initially; however, when multiple investments are involved, looking at returns may become complicated. Hence, the Extended Internal Rate of Return (XIRR) is important, as it helps to track investments.

What is XIRR?

Extended internal rate of return, or XIRR, is a financial metric used to calculate return on investments where multiple transactions occur at different time periods.

Unlike a simple rate of return, XIRR aims to provide an accurate estimate of returns by taking into account the cash flows made at different time periods instead of just looking at the total amount invested.

It is beneficial to calculate return on SIPs as it includes multiple investments at different prices and time periods, which makes it difficult to calculate accurate returns. Hence, XIRR is typically used for SIP investments where money is invested at different times, giving an accurate estimate of the annualised return on mutual funds.

How to calculate XIRR?

XIRR can be calculated using Microsoft Excel or Google Sheets. Excel has a built-in function to calculate XIRR.

How to calculate XIRR in Excel?

Step 1: In one column, enter all the transaction details, such as outflows, including investments and purchases as negative and all inflows as positive.

Step 2: Add the date of the transaction in the next column.

Step 3: Enter the current value of holding and date in the last row.

Step 4: Use the XIRR function in Excel, which is =XIRR (values, date, guess).

XIRR or CAGR

Similar to Extended Internal Rate of Return (XIRR), Compound Annual Growth Rate (CAGR) is a measure to estimate the rate of return investments. However, CAGR calculates the mean annual growth rate of investment for a specific period of time, while XIRR measures return on investments with irregular cash flows on different dates.