Measuring Progress – XIRR as Personal Rate of Return

investingInvestor’s who use long term buy and hold philosophy use varied different ways to manage risk (such as allocation and diversification), monitor their progress, and performance metric. There is no single metric that can be considered as a holy grail of progress monitoring and/or performance measurement. Depending upon what is the objective and what you want to achieve is what will drive that performance metric.

In this context, I use few different monitoring and/or performance metric. Earlier, I have talked about yield on cost as one metric to determine cash flow (or dividends) received from my original investments. YOC is a very good metric to measure the growth of your dividend based cash flow over a period of time. However, it has a drawback. It does not take into account the variability of capital invested. The price of the stock does not remain static. It keeps changing over a period of time.

I have observed that it is a general practice among individuals to use percentage based metric to determine the returns. Folks use the difference between present value and original value, and come up with a percentage. This approach is good for calculating the absolute portfolio performance at a given point in time. The drawback with this method is that it does not provide time-weighted return for our investments. Let us example. My original investment is Rs 100. After few weeks or months or years, I sold it for Rs. 300. So we consider 200% as our return [300-100]/100. In this calculation, we did not include the time factor. Is our 200% return in one week, one month, or one year?

In my investment process, I keep investing multiple times, I get dividends at various different time scales, and still further, the values of the stocks are different. Since I give different time frames for each individual investment and returns, I need to determine the time-weighted returns. Many folks also term it as personal rate-of-return or XIRR. The metric XIRR can be calculated either for full portfolio or for individual stock’s performance.

For simplicity, XIRR is the interest rate you would need to make the same money from any interest bearing account (with same investment).

How is this different than compounded annual growth rate (CAGR)? Well, in reality CAGR is not the actual return. It is a calculated or derived number which tell us rate that which an investment would grow if this growth rate was a steady rate. It averages out the returns over a period of time which gives a false impression. Mutual funds use this metric in their performance chart because this provides a rosy picture. The CAGR of mutual funds are not your personal returns. More on this sometime in future post.

Suffice to say, I do not use CAGR metric and instead I use XIRR. In the next post I will discuss an example of how I use XIRR to measure my stock’s performance.

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