Learn How to Calculate Your Internal Rate of Return
IRR Helps You Compare Investment Options
It should be easy to calculate the rate of return (called an internal rate of return or IRR) you earned on an investment, right? You would think so, but sometimes it is more difficult than you would think.
Cash flows (deposits and withdrawals), as well as uneven timing (rarely do you invest on the first day of the year and withdraw your investment on the last day of the year), make calculating returns more complicated.
Let's take a look at an example calculating returns using simple interest, and then we'll look at how uneven cash flows and timing make the calculation more complex.
Simple Interest Example
If you put $1,000 in the bank, the bank pays you interest, and one year later you have $1,042. In this case, it is easy to calculate the rate of return at 4.2%. You simply divide the gain of $42 into your original investment of $1,000.
Uneven Cash Flows and Timing Make it More Difficult
When you receive an uneven series of cash flows over several years, or over an odd time period, calculating the internal rate of return becomes more difficult. Suppose you start a new job in the middle of the year. You may invest in your 401(k) through payroll deductions so every month money goes to work for you. To accurately calculate the IRR you would need to know the date and amount of each deposit and the ending balance.
To do this type of calculation you need to use software, or a financial calculator, that allows you to input the varied cash flows at differing intervals. Below are few resources that can help.
- Here is a free that allows for up to fifteen years of cash flow entries.
- You can also download a Microsoft Excel , which explains how the IRR function in Excel works and allows you to input cash flows to see how it works.
- For those of you who like online tutorials, this .
Why Calculate Internal Rate of Return?
It is important to calculate the expected internal rate of return so you may adequately compare investment alternatives. For example, by comparing the estimated internal rate of return on an investment property to that of an annuity payment to that of a portfolio of index funds, you can more effectively weigh out the various risks along with the potential returns - and thus more easily make an investment decision you feel comfortable with.
Expected return is not the only thing to look at; also consider the level of risk that different investments are exposed to. Higher returns come with higher risks. One type of risk is liquidity risk. Some investments pay higher returns in exchange for less liquidity - for example, a longer term CD or bond pays a higher interest rate or coupon rate than shorter term options because you have committed your funds for a longer time frame.
Businesses use internal rate of return calculations to compare one potential investment to another. Investors should use them in the same way. In retirement planning, we calculate the minimum return you need to achieve to meet your goals and this can help assess whether the goal is realistic or not.
Internal Rate of Return Is Not the Same as Time Weighted Return
Most mutual funds and other investments that report returns report something called a Time Weighted Return (TWRR). This shows how one dollar invested at the beginning of the reporting period would have performed.
For example, if it was a five-year return ending in 2015, it would show the results of investing on January 1, 2001, through December 31, 2015. How many of you invest a single sum on the first of each year? Because most people do not invest this way there can be a large discrepancy between investment returns (those published by the company) and investor returns (what returns each individual investor actually earns).
As an investor, time weighted returns do not show you what your actual account performance has been unless you had no deposits or withdrawals over the time period shown. This is why the internal rate of return becomes a more accurate measure of your results when you are investing or withdrawing cash flows over varying time frames.