IRR and Returns on Portfolios

There is a very interesting discussion at the Canadian Capitalist’s blog about how to determine performance and there was some talk of Internal Rates of Return (IRR):

In one comment, the Canadian Capitalist, said:

It is true that IRR is the true measure of performance but what I did in my earlier post was compare the IRR of my actual portfolios with the annual return of the benchmark (to which no money was added). That is really comparing apples to oranges.

He is referring to the fact that is benchmark sleepy portfolio earned 14.7% last year vs. a 9.55% annualized return (for last year) for his own portfolio.

I have a reply to that that is kind of long so I thought I’d post it here:

I think it is ok to compare your porfolio’s IRR to the annual rate of return of the benchmark. I went back to the definition of IRR since I had sort of lost track of what it really mean, and this sentence sort of brought it home for me:

IRRs can also be compared against prevailing rates of return in the securities market. If a firm can’t find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market.

When companies do this, they are comparing some IRR calculated with some complex set of cashflows to the prevailing annual rate of return in the market. The benchmark’s annual return is an IRR too, there is just one cashflow in, one cashflow out.

Essentially what I think happened with the CC’s portfolio is that his further purchases during the year were at (relatively-speaking) high points in the market. And the IRR comparison to the annual return of the index is correct. He had a worse return than someone investing all of their money in the index at the beginning of the year did.

But, the bigger/better question is, would he have done better had he put his cashflows throughout the year into the index/(or in his case, the sleepy portfolio). Well it depends on timing and what happened in the market but I think an IRR calculated from those cashflows might be interesting, because it would show how well he would have done had he invested in his benchmark portfolio instead of his real portfolio. So the IRR really can show you how well you did by revealing bad timing and such.

I just did the XIRR calculation on a spreadsheet to check this…but it looks like if we were comparing an IRR of a portfolio made up of purchases of an index ETF made throughout the year, let’s say, and the daily return was the same for every day of the year, the IRR of your portfolio would match the annual return of the index exactly. So I think it might be true that in the limit of a linearly increasing/decreasing market/investment, the annual return is equal to the IRR of any cashflows invested in that market/investment.

No time to look this over or spellcheck this, so I’m sorry, but I’m really busy!

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