IRR Discussion

We've been having a lively discussion about the proper way to measure returns on the MFI board. I have been a strong proponent of Internal Rate of Return, which I use here. The best part about IRR is that it allows you to add money or remove money from the investment and still calculate a number that is meaningful.

For instance, I may add $10,000 to my MFI investments in 2007. If I just calculate a simple return, my return will drop because I add $10,000 to the denominator and numerator. IRR accounts for the actual cash flow and the timing of the flow. Of course the negative about IRR is that it is more difficult to calculate. OpenOffice Calc spreadsheet (a free download recommended by PC World) does a good job though. I don't know why Yahoo! doesn't calculate it when you select the transaction level portfolio.

Here is a definition of IRR:

Internal Rate of Return (IRR) is the discount rate which sets the NPV of a series of cash flows equal to zero. It tells us what our compound rate of interest is on our investment.

To turn that into English, I will give a simple example:

Suppose you have a very simple cash flow. On January 1st you invest $100. Then on December 31st you receive $110. You want to find the discount rate (i) that makes the net present value of the cash flow = 0. We will define investments as negative cash flow and portfolio value and dividends as positive cash flow.

(1+i)^1 * (-100) + (1+i)^0 *(105) = 0 doing some algebra (don't have to do this when you have a calculator):
-100 -100*i +105 = 0.
5 -100*i = 0
100 *i = 5
i= .05 = 5%

The math obviously gets more complex when you do it on a daily basis instead on annually. Also many transactions such as buying and selling stocks along with dividends make it more complicated. But a spreadsheet handles it all with ease.

A quick note on my stocks. I saw where Cramer is bearish on ANF. He sure runs hot and cold, not sure what happened to his prediction of ANF getting to $85. He also interviewed CEO of VFC and asked him if they intended to buy TBL. While the CEO obviously refued to comment, that would be very nice.

Have a great day... glad my Cowboys beat the Giants! And my Mavericks have won 12 straight. Life is sweet right now.