An explanation of 'internal rate of return' and other tricky ways to evaluate performance.
In the first year you went, let us suppose, from $100,000 to $180,000, and in the second from $180,000 to $206,000. The two annual moves are 80% and 14.4%. Those two numbers average to 47.2%. Is that your average annual return? It is more defensible than 53%, but still not entirely honest.
Go to Morningstar.com, search for VTI and select the Performance tab. You’ll see returns for the calendar year to date and the trailing 1, 3, 5, 10 and 15 years. You’re looking at the performance of a fund, not an index, but it’s good enough for most purposes. The difference between the two is tiny because the fund’s expenses are tiny.
Add the added money to the starting value. Turning $150,000 into $206,000 represents a gain of 37.3%, or a compound annual 17.2%. What discount rate zeroes out this string of cash flows? Let’s try 20.7% and see what happens. The present value of today’s $100,000 is $100,000. The present value of next year’s contribution is equal to $50,000 divided by the sum of 1 and the discount rate. Discounting at 20.7% would make that future sum equivalent to $50,000/1.207 in today’s money, or $41,400.
So IRR is telling you that you are a good stock picker, with a 12% annual return, and simultaneously telling you that your are an idiot with a negative 6% annual return. Gospel truth? Not quite. You might be curious about what caused that last hypothetical portfolio to have imaginary IRRs. It has to do with the account going to $0. So long as the account starts and ends with a positive balance, there will always be at least one real IRR , but there is still the possibility of more than one correct answer.
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