Earlier this month, I promised an article on the best way to track your portfolio performance: the internal rate of return (IRR). IRR is the same concept as the more familiar APY (annual percentage yield) on a bank certificate of deposit (CD) or money market fund. Quite simply, IRR is a portfolio's annualized rate of return, taking into account both the amount of money invested and the length of time it has been invested.
Why is it worth your time to understand IRR and track it for your own portfolio? Because we as investors are up against quite a challenge in seeking to outperform the Standard & Poor's 500 Index. If you're not keeping score with IRR, then you might not know who's truly winning the game.
Let's talk for a minute about what we're up against with the S&P 500. Consider that by choosing to invest in individual stocks we forego the convenience of minuscule fees, low turnover (and consequently low taxes), broad diversification, and regular maintenance by the good folks at Standard & Poor's who occasionally replace a laggard with a rising star to make sure the index is representative of America's biggest and brightest. And, let's not forget the S&P still whips most fund managers year in and year out.
Many, many investors would do well to never venture beyond the simple index fund, whether of the S&P 500 or Total Stock Market (Wilshire 5000) variety. (You can compare the various indexes in our Motley Fool Index Center.) But if you're going to give it a go with individual stocks -- and I certainly think the payoff is worth it for the motivated and intellectually curious individual -- then you owe it to yourself to track your performance against the S&P 500 benchmark, and to track it right.
Even our Rule Maker Portfolio is only outperforming the index by a smidge on a historical basis (as of market close, 10/27/00):
IRR Overall Return Rule Maker 12.62% 30.07% Comp. S&P 500 11.85% 26.90%
You may be wondering -- in fact, I hope you're wondering -- what the heck the difference is between IRR and overall return.
Overall return tells you how much money you've made, plain and simple. The Rule Maker has deposited a net sum of $32,276 into its account since January 6, 1998. If you take that amount and multiply it by our overall return of 30.07% (that is, 1.3007), the result is $41,981.39. You'll notice that matches (within less than $1.00, due to a rounding error) the total portfolio value listed at the bottom of Friday's column. Thus, overall return is simply the percentage gain (or loss) on your invested capital.
IRR, on the other hand, tells you how fast (or slow) you're making money. The concept goes like this: IRR looks at all of your deposits and withdrawals, and the exact timing of each deposit and withdrawal. Then, it looks at your current account value. Finally, IRR finds the single annualized rate of return that mathematically matches your current account value to all of your deposits and withdrawals. It's hard to mentally conceptualize, but the important thing to note is that IRR fully takes into account the time value of money. That's why I consider IRR the most accurate way to measure portfolio performance.
So how do you calculate IRR? You don't; you let a computer do it. The reason for this is because the IRR calculation requires a process of trial and error ("interpolation"), by which the computer tries various rates of return until it narrows down to the one that matches all of the deposits and withdrawals with the current account value.
You're scratching your head, "Okaaaaaaaaay."
Here's an analogy that may help:
Let's take a trip. We're all hitting the road to celebrate the fall season by driving from Alexandria, Virginia up to Sleepy Hollow, N.Y. It's a trek of about 260 miles. Half of you pile into the Family Truckster with me. The other half choose to ride with Zeke in the FoolMobile. Now, Zeke drives kind of slow, whereas I'm practically on the state police's Most Wanted. Sure enough, my crew makes it up there in three hours flat, a full hour ahead of Zeke.
What was my "overall return"? 260 miles. What was Zeke's "overall return"? The same, 260 miles. We both accomplished the same goal of completing the trip. The difference was in our rate of speed. I averaged an "IRR" of almost 87 miles per hour (260 miles / 3 hours), whereas Zeke's "IRR" was an even 65 miles per hour (260 miles / 4 hours).
So, overall return is certainly an important piece of information. It answers the basic question of "How much do I have now based on how much I put in?" But time is the ultimate arbiter of investment returns. And only IRR can accurately measure a time-based rate of return within a dynamic portfolio such as the Rule Maker. By "dynamic," I mean a portfolio that has additional deposits and/or withdrawals beyond the initial deposit to fund the account. As you probably know, the Rule Maker Port adds $500 every month. If, like us, you make ongoing deposits and withdrawals from your portfolio, you'd do well to evaluate your returns using IRR. Otherwise, you don't really know how well you're doing.
Yes, IRR is mathematically complex, but worry not -- our free My Portfolio stock-tracking tool does all the work for you. Just input your deposits, withdrawals, trades, and dividends, and My Portfolio measures your portfolio's IRR (which it calls "My Annualized Return" -- a much friendlier name than IRR) and compares it to the comparable IRR of the S&P 500 (or your choice of benchmark). My Portfolio can even measure the individual IRR of each of your holdings, with each compared to the benchmark's comparable performance. I find it quite interesting to look at how the Rule Maker's holdings have performed on an individual IRR basis compared to the S&P 500:
RM S&P 500 Cisco 62.14% 6.03% Intel 31.08% 9.34% American Exp. 23.24% 9.62% Pfizer 19.01% 12.26% Microsoft 15.26% 10.49% T. Rowe Price 8.96% 12.26% Schering-Plough 3.56% 11.79% Coca-Cola -5.08% 10.81% Nokia -11.86% -0.52% JDS Uniphase -31.63% -2.29% Yahoo! -32.59% 4.73%
As you can see, we've only "created value" (that is, generated returns higher than available in the index) with five of our 11 companies. But our one big winner, Cisco, has buoyed the entire Rule Maker ship. But that's another lesson for another day.
Finally, you may be wondering about the "annualized" return that's currently listed for the Rule Maker at the bottom of this page. That number is the annualized version of the overall return, which is NOT equivalent to IRR. An annualized version of the overall return pretends as if all the portfolio's invested capital were invested since the first day of the portfolio's existence (1/6/98). In the case of the Rule Maker Port, we actually began with only $20,000 -- less than two-thirds of the total invested capital as of today. As such, an annualized version of the overall return actually understates our rate of return.
When you look at the port returns as we have them listed now, I recommend evaluating our performance based on the "since 1/6/98" column for Rule Maker vs. the Comparable S&P 500. This is a direct, apples-to-apples comparison of our overall return versus what we would've achieved if we'd invested every dollar (on the day of deposit) in the S&P 500.
Soon, we'll be adding IRR to the portfolio return information to give you a more three-dimensional scorecard of our portfolio's performance. If you're interested in learning more about IRR, Phil Tubb (TMF Radish) offers some excellent supplementary information in this discussion board post (scroll down to "My Annualized Return" and "A note about annualized returns"). In that post, he answers the very commonly raised objection that IRR is inaccurate because it projects your return so far over an entire year. I encourage you to read his post to gain an understanding of why this objection poses a false dilemma.