For all the reasons outlined above, performance calculations are more complex than they first appear. We discuss different ways to calculate performance. Each method has advantages and disadvantages. And not every investment company calculates returns the same way. First, we look at the method our providers use, called the “IRR.”
Our providers use the Internal Rate of Return (IRR) Calculation method. The Internal Rate of Return (IRR) is used to calculate the money-weighted rate of return. Like the Modified Dietz calculation, discussed elsewhere, we value the portfolio at the starting and ending points of the period. Cash flows are included based on their timing.
The IRR is related to the time-value of money or present value formula. It calculates the discount rate which will take the starting value and all cash flows to result in the ending market value. This type of calculation looks at the actual returns on dividends, sales or other deposits, which is a clear difference from the other types of performance calculations.
Large cashflows dominate small cashflows—they have a much larger effect on your percentage returns. Similarly, the most recent period of time dominates returns—for better or worse. Keeping money in cash hurts returns because the cash is included in the calculation—this is different than the two other methods, discussed next.
To be clear, the providers we use for performance reporting show the internal rate of return (IRR), not any other calculation.