The Extended Internal Rate of Return (XIRR) is the annual rate of return; it considers every installment/redemption made by an investor during the investment period. XIRR is a more apt indicator of returns on investments where there are multiple transactions taking place at different times.

If we are to invest in a smallcase, as a first step, we ideally check the smallcase returns for the past 3 years, 5 years, etc. These returns are point-to-point returns and are called Compounded Annual Growth Rates (CAGR).

For example, if 3-year returns for X smallcase is 12%, and the initial investment amount is considered to be ₹10,000. After a period of 3 years, according to CAGR, the current value of the smallcase becomes ₹14,049.28.

CAGR can be simply calculated by using the formula :

While CAGR gives a good picture of returns for one-time investments but for investments made over a duration of time it becomes tricky.

Let’s say you make a monthly SIP of ₹10,000 for 3 years. So, you have invested in 36 installments and at the end of 3 years, your portfolio value is ₹4,00,000.

At the end of the 3 years if you want to calculate your portfolio return you will have to calculate the CAGR for 35 months, 34 months, 33 months, and so on, for different investments you made, and hence quite complicated.

XIRR makes this simpler by calculating one return for your investments which is representative of your portfolio returns taking all cash flows into consideration.

The inputs to the calculation of XIRR are -

Based on an iterative method, the XIRR of the portfolio is calculated using the standard XIRR formula.

What are cash flows?

Any user action in a smallcase - Buy, Invest More, SIP, Rebalance, Manage, Partial Exit, Whole Exit. All of these constitute cash flow.

Cashflow on any day can be calculated by the total buy amount minus the total sell amount. In addition to these cash flows, some corporate actions also have an impact on the cashflow - Dividends, Split/Bonus/Demerger where the adjustment ratio is done in such a way that realized return is impacted.

XIRR is a great measure for computing returns of investments older than one year because it’s an annualized return metric. Showing annualized returns for periods less than one year inflates the results by the assumption that money could be reinvested and the same returns are earned over and over again, for a full year. Absolute returns should be the figure of guiding returns for investments of less than a year.