NAV method gives you time weighted returns (TWR). XIRR gives you money weighted return (MWR). Difference comes from timing and size of cashflows. XIRR and NAV returns are same when there are no cashflows between beginning and ending period. If there are cashflows between beginning and ending periods, XIRR and NAV methods will give you different returns.
NAV based returns are independent of cashflows. i.e. NAV returns does not change even if there are large or small cashflows in the portfolio. This is the correct way for mutual funds to calculate their returns as they do not control when investors buy or sell MF units. Returns reported by Mutual Funds are TWR returns.
MWR returns take into account timing and size of cashflows hence they are called Money Weighted Return. MWR is the actual return an investor earns as it considers both the amount and timing of the actual money invested.
Both methods require you to value your portfolio at regular intervals and on all days there is a net cash inflow or outflow in the portfolio. Mutual Funds do it on a daily basis as they have cashflows on a daily basis. For individuals, a monthly valuation is easy as your DP will send you a monthly holding statement that will have market value of your portfolio at end of the month. Interestingly, you don’t need to record your buys and sells as all your trades will be eventually reflected in the closing value of your portfolio and cash balance.
long term TWR is generally considered as return to strategy (or strategy return) as it is the return you are likely to get if you continue to apply the same strategy in the long term.
MWR return is the actual return investor earn as it takes into consideration timing and size of cashflows.
Both methods will allow you calculate returns over any period as long as you have beginning and ending value of your portfolio (including cash) and all cashflows and their dates.
Since MWR return take into consideration timing and size of cashflows, it is a good indicator of asset allocation and market timing skills of the investor while TWR is a good indication of stock selection and portfolio construction skills.
If MWR returns for a period are less than TWR returns for the same period then investor’s market timing skills are not good as it indicates investor is generally buying after a positive return and selling after a negative return. Similarly if MWR returns for a period are higher than TWR returns for the same period then investor has superior market timing skills as it indicates investor is generally adding cash to portfolio just before a positive return and taking cash out just before a negative return.
Quiet often mutual fund earn a good return (TWR) but investors in mutual fund earn a lower return (MWR) as they are generally bad at timing the market.
If you have been following a strategy for a number of years, you should calculate both TWR and MWR returns. TWR is the return you are likely to earn if you continue to follow your current strategy in the long term. If your MWR return is less than TWR, then you should try to improve your asset allocation (aka market timing) skills as It indicates that although you have a good stock selection strategy, you are unable to invest correct amount of money in your own strategy.