Keeping track of how your money is growing is essential, whichever product it might be. It becomes even more important if you are handling your money yourself, especially by investing directly in shares. A critical concept for self-directed investors is understanding how to calculate the Internal/Intrinsic Rate of Return (IRR). This measurement provides a clear view of how well your investments are performing over time, accounting for all cash inflows and outflows.
What is IRR?
The IRR represents the annualised growth rate of your investments. It is particularly valuable because it considers the timing of your cash flows, such as when you bought more stocks or received dividends. The formula for calculating IRR can easily be applied in Microsoft Excel using the function: `=XIRR(values, dates, 10)’.
To calculate your IRR, follow these steps:
1. List Your Cash Flows in an Excel spreadsheet - all the money you’ve invested in your stocks (pay-ins), including dividends received and any pay-outs (redemptions). This has to be along with dates.
2. Use the XIRR formula mentioned above - the IRR function will provide you with an annualized growth rate that reflects the overall performance of your portfolio.
Why is IRR Important?
Calculating IRR is crucial for self-managing your investments. It allows you to compare your portfolio’s performance with other financial products. If your IRR is around 20-25%, it may be worth the effort to invest in stocks yourself. However, if your returns fall below this, it might be more beneficial to consider mutual funds or seek advisor’s help for investing in stocks or invest in a portfolio management scheme (PMS) of stocks. This reduces your time, efforts and resources of managing a stocks portfolio. Mutual funds are the easiest and convenient route to invest in stock markets. Some mutual fund schemes have historically delivered returns of 15-20% over 5-10 years. The returns can be higher if your mutual funds portfolio is focused on midcap and smallcap stocks. Why handle the hassles of investing by yourself when you can outsource?
Making Better Investment Choices
The IRR formula isn’t just useful for stocks. It can also be applied to various financial products, such as insurance schemes and real estate investments. By calculating the IRR for different assets, you can determine whether your investments are working as hard as they should. Understanding your IRR is vital in ensuring your money outpaces inflation and delivers better returns than competing products. Whether you’re a beginner or an experienced investor, calculating your IRR can help you make informed decisions about your investments. If you need assistance, there are many resources and experts available to guide you.
Remember, your money should work hard for you, just as you work hard for your money.
(The author is a Chartered Accountant and CFA (USA). Financial Advisor. Views personal.)
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