November 15, 2024
There are two key terms that are bound to come up in any discussion involving the assessment of an investment’s performance – CAGR and IRR. The key difference between CAGR and IRR is that the former helps you calculate the return on an investment over time while IRR measures investment performance. CAGR is relatively easy to calculate. Read on to know the differences between these two terms.
An investment’s compound annual growth rate is a measure of the average annual growth of the investment. The CAGR, assumes that the returns earned from the investment are reinvested at the end of every year. You can easily compare two investments and their past performances based on their CAGRs. You can use a compound annual growth rate calculator to calculate your investment’s CAGR accurately. A point that you must keep in mind while understanding CAGR is that it does not account for investment risk or market volatility while calculating a fund’s annual growth rate. It assumes constant growth, which might not be accurate for all investments.
IRR or “Internal Rate of Return”, on the other hand, is used to evaluate the profitability of an investment. It reflects the percentage rate earned on each rupee invested for each period it is held. You can use IRR to compare the potential returns of different investments. It provides you with a comprehensive view of your investment’s performance over time. IRR, however, is not very effective for investments that have an unconventional cash flow pattern.
The following table elaborates on the key differences between the Internal Rate of Return (IRR) and CAGR (compounded annual growth rate) –
| Feature | IRR | CAGR |
| Definition | The IRR calculates the profitability of potential mutual fund or stock investments by considering all cash flows. | CAGR measures the mean annual growth of an investment over a year. It indicates the average returns that a fund can earn over a year. |
| Application | IRR is used for comparing various investments that offer different cash flows. | CAGR is a metric used to compare the growth rates of different investments over time. |
| Considerations | IRR considers the timing and amount of each cash flow while calculating the overall profitability of an investment. | CAGR assumes constant growth over a given period and ignores the specific timing of returns. |
| Suitability | IRR is a better metric for complicated investments that have varying cash flows. | CAGR is a better metric to analyse a simple investment that has a clear beginning and end date. |
While seriously evaluating an investment’s performance, using IRR to do so is a more conservative and accurate measure. This is true since IRR accounts for market volatility and the realities of the financial world, whereas CAGR does not account for these factors. The truth is that every investment experiences volatility, and since CAGR does not account for it in its calculations, its estimates are not as trustworthy as IRR’s. If you do wish to calculate CAGR to compare two investments, you can use a CAGR calculator online to do so.
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