IRR- Internal Rate of Return
The IRR is a percentage value which explains the way we got from the initial portfolio value to the current portfolio value, taking into consideration all the money taken out of and put into the portfolio along the way. Since most people need to add and subtract cash from their invested assets over time, the IRR does a significantly better job of explaining changes in an investor’s wealth than the annualized return does. Sometimes your small business accountant will notice that the IRR for the same portfolio is lower in this example because the IRR takes into consideration the fact that a large contribution was made to the fund right before a large downturn.
Most investment advisors are not interested in providing their clients with an IRR as a performance measurement. First, providing the IRR requires a log of all transactions into and out of a client’s portfolio. Moreover, IRRs can often be less flattering to investment advisors’ performance than annualized returns are. Despite the resistance to provide an IRR, individuals should insist that their financial advisors provide such a measure in order to get a clear idea of the progression of their wealth over time.
Risk-Adjusted Performance Measures
IRR is not a perfect performance measure because it does not account for the riskiness of investments in computing the return accrued to the investor. Much more important than the return to investors is the return per unit of risk. Just as it is unreasonable to assume that equities are always a better investment than government bonds, so too, it is unreasonable to judge investment managers based solely on their returns without considering the risks they take.
There are a few standardized measures of risk-adjusted return, but these, too, are imperfect performance indicators. Each one measures risk as the volatility of returns rather than the risk of permanently losing money. For wealthy individuals, who often have sufficient cash or incomes to weather short-term volatility, these measures fail to encapsulate the role of an investment manager or advisor.
A Reasoned Approach to Performance Evaluation
It is crucial that clients evaluate their investment professionals based on a combination of factors rather than any one single number. IRR and risk-adjusted performance measurements are useful because they measure some very important aspects of investment performance.
In the end, IRR, risk-adjusted returns, and other performance factors should all be considered by clients looking to get a comprehensive understanding of a financial professional’s performance. Clients should insist on the availability of all these important pieces of information so that they can make informed decisions. When you’ve entered the investment game, it’s important that your small business accountant get involved with your portfolios and IRR quotients.