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You may have heard of a return on investment, but have you ever heard of an investment measure called the internal rate of return?
The return on investment (ROI) – sometimes called the rate of return (ROR) – is the percentage that an investment has increased or decreased over a certain period of time.
By contrast, the internal rate of return (IRR) measures the actual return achieved by an investor’s money in a portfolio. The IRR calculation takes all fees, the time of investment, additional investments and withdrawals into account and then calculates the growth of the investment in a meaningful way.
This then enables an investor to determine whether their portfolio is on track to achieve the return required for them to meet their lifestyle objectives. The IRR calculation looks at a portfolio's return on an annualised (in othere words on a per year) basis. If, for example , you had R100 on 1 January and R110 on 31 December and made no deposits or withdrawals, your IRR would be 10% for the period.
If, however, you made monthly deposits of R1 (in other words R12 in total) and your portfolio is worth R110 on? 31 December, you would have a negative IRR of -1.9%. After investing a total of R112, you would be left with less money (R110) than you had put into the investment.
If, on the other hand, you withdrew R1 every month and you have R110 at the end of the year, your IRR would be 23.2%. You would have had cash flow of R12 during the year as well as ending the year with an additional R10 in the investment.
This IRR calculation is also referred to as a money-weighted return calculation. This is different from a more traditional time-weighted return where we exclude any client-generated cash flow in and out of the portfolio and only look at the initial value (R100) and the final value (R110). Ignoring how much money had been added or withdrawn over the same period, the return is calculated as 10%.
While these are greatly simplified examples, they illustrate the importance of knowing a portfolio's IRR. In reality, additional items such as fees are also 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 your progress towards achieving your financial goals. It indicates the actual return that you have achieved over the period including cash flows in and out of your portfolio.
By comparing the IRR to your required rate of return – the rate that your portfolio needs to achieve in order to meet your living 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 different IRR because their deposit and withdrawal patterns are different. Let’s say, for example, that the market increases by 10% over the year, but it first goes through a valley with a drop of 5% in the middle of the year.
If one person added to their portfolio in the valley while another made a withdrawal in the valley, it means that one bought at a discount while the other realised a loss. In this example the portfolios’ overall performance was the same but their individual IRR will be very different.
If, during a financial planning exercise, calculations showed that you need an annual return of 3% above inflation to achieve your lifestyle objectives, then the calculation assumes that as long as the money is invested in your portfolio, it is getting 3% above inflation.The IRR calculation is the most appropriate formula to check whether you are actually getting what your financial plan says you need.
Paul Leonard, a certified financial planner, is regional head at Citadel.
This article originally appeared in the 15 June edition of finweek. Buy and download the magazine here.
