You may have heard of a return on an investment, but have you heard of an investment measure called the internal rate of return (IRR)?
The return on investment (ROI) – sometimes called the rate of return (ROR) – is the percentage by which an investment has increased or decreased over a certain period. By contrast, the IRR measures the actual return on an investor’s money in a portfolio.
The IRR calculation takes into account all fees, the investment term, and additional investments and withdrawals, and calculates the growth of the investment in a meaningful way. This enables investors to determine whether their portfolio is on track to achieve the return they need to maintain their standard of living.
The IRR calculation shows a portfolio’s return on an annualised (per year) basis.
If, for example, you had R100 on January 1 and R110 on December 31, and you made no deposits or withdrawals between those two dates, your IRR would be 10% for the period.
If, however, you made monthly deposits of R1 (or R12 in total) and your portfolio was worth R110 on December 31, you would have a negative IRR of –1.9%. After investing a total of R112, you would have less money (R110) than you invested.
If, on the other hand, you withdrew R1 every month and you had R110 at the end of the year, your IRR would be 23.2%. Your cash flow during the year would have been R12, and you would have ended the year with an additional R10 in the investment.
The IRR calculation is also referred to as the money-weighted return calculation. This is different from a traditional time-weighted return where we exclude any client-generated cash flow in and out of the portfolio and look only at the initial value (R100) and the final value (R110) and get a return of 10%, which ignores how much money had been added or withdrawn over the period.
Although these are very simple examples, they illustrate the importance of knowing a portfolio’s IRR. In reality, additional variables, such as fees, are taken into account, thereby providing a more realistic picture of your return.
Knowing your portfolio’s IRR is important, because it enables you to monitor whether you are progressing towards achieving your financial goals. It indicates the actual return, including cash flows in and out of your portfolio, over the period.
By comparing the IRR to your required rate of return – the rate that your portfolio needs to achieve in order to meet your lifestyle requirements, for example, inflation plus 2% – you will be able to assess your progress towards your goal.
Interestingly, two people may be invested in the same portfolio but have a different IRR, because their deposit and withdrawal patterns are different.
Let’s say, for example, that the market increases 10% over the year, but it first goes through a valley, falling 5% in the middle of the year. If Investor A added to her portfolio while the market was in the valley, whereas Investor B made a withdrawal, it means that Investor A bought at a discount, while Investor B realised a loss. In this example the portfolios’ overall performance was the same, but their individual IRRs will be different.
If, during a financial planning exercise, calculations show that you need an annual return of 3% above inflation to achieve your lifestyle objectives, the calculation assumes that, as long as the money is invested in your portfolio, it is earning 3% above inflation.
The IRR calculation is the most appropriate formula for checking whether you are actually earning what your financial plan says you need.
* Paul Leonard, an accredited Certified Financial Planner, is the regional head in the Eastern Cape of national advisory practice Citadel.