Internal Rate of Return (IRR) is the single rate of return at which the beginning market value plus additions grows to equal the ending market value minus withdrawals.
PortfolioCenter calculates IRR using an “iterative process”. Basically PortfolioCenter keeps trying numbers until it finds a single rate of return that makes (Beginning Value + All Contributions) = (Ending Value – All Withdrawals).
While the return may have bounced wildly up and down during the time period, IRR is the hypothetical straight line between the beginning value and ending value.
In IRR it’s all relative.
In IRR, timing and size of capital flows relative to market movement and the total portfolio value make a big difference. In general:
- The larger the position, the greater the impact of market changes.
- The larger the deposit/withdrawal, the more it affects IRR.
- Adding or removing a large amount before a market swing has dramatic affects on IRR.
- The smaller the time span being measured, the more the IRR is affected by flows and market movement. The larger the time span, the less affect.
- The higher percentage of the total portfolio the amount of a deposit/withdrawal, the more it changes IRR.
- A deposit/withdrawal at the start of the time period has more affect than one at the end of the time period.
Why trying to make sense of a strange IRR, I look for these 3 things first:
- Moving a large amount of money in or out of the portfolio on the first day or the last day of the reporting period.
- Moving a large amount in or out of the portfolio during a period when the market experienced a large swing in value.
- A short reporting period, especially if that time period was volatile.
Why use IRR?
In my opinion IRR is most useful as a measurement of an individual holding. If you want to know how a particular position did during a particular time period in a particular portfolio, IRR is the most accurate indicator.
If you want to measure overall portfolio performance, Time Weighted Return (TWR) is the better measurement.