During my early years as an investor, I was content with the returns I received on my investments, irrespective of whether they were high or low. I relied on my accountant as my advisor, blindly investing wherever he recommended. As long as my money was growing, I didn't pay much attention. Perhaps, this was a common narrative during that time.

However, times have changed now. There is greater awareness surrounding investments. As a financial investment advisor, myself, I am well-aware of the questions that arise. What options do I have? Is this investment secure? When will I start seeing returns? Can I be guaranteed the promised returns? Can I access my funds whenever I want? What is the level of risk involved? Some even inquire about my commission, not that it matters to me. Knowledgeable investors often inquire about the Internal Rate of Return (IRR) as it helps them to assess the profitability of their investment.

“Ultimately an investment is an instrument of trust as much as it is of belief.  Every single part of your strategy is showing you're accountable and understand your responsibility with that. Take ownership.” ― Henry Joseph-Grant

So, what is IRR and what is its purpose?

IRR is the annualized rate of return for a given investment – no matter how far into the future. It allows you to measure the profitability of your investment over a specific period of time and is expressed as a percentage. Say, you have an annual IRR of 11%, that means you now have 11% more of something than you did 12 months earlier.

Now, this serves as a valuable decision-making tool when comparing alternative investment choices. You can compare the IRRs of different investments, prioritize and select the choices that offer the most attractive returns relative to their risk tolerance. But, here’s the thing... while IRR effectively highlights the time value of invested capital, it alone does not offer a comprehensive assessment of potential risk.

To gain a more accurate understanding of risk, it is necessary to combine IRR with other metrics that would allow for thorough scrutiny of investment opportunities. Many investors either lack an understanding of IRR and its susceptibility to manipulation or don’t use this measure because it is confusing and difficult to calculate. But a savvy investor would at least ask what the IRR is if he were to make a certain investment choice.

Let’s suppose you are an investor evaluating two investment choices: Choice A and Choice B.

Choice A requires an initial investment of ₹10,000 and is expected to generate cash flows of ₹2,500 per year for 5 years. Choice B requires a larger initial investment of ₹20,000, but it is expected to generate higher cash flows of ₹5,000 per year also for 5 years.

Now, if you calculate the internal rate of return for both the choices to assess their potential profitability, Choice A comes out to be 10%, and the IRR for Choice B is 8%. However, even though the IRR for Choice A appears higher, it fails to consider the initial investment amount and the actual rupee value of the investments. You invested twice as much in Choice B, which might still result in higher absolute returns despite its lower IRR.

"The most important quality of an investor is patience." - Peter Lynch

What does IRR not do?

It does not compare the holding periods of the investments nor does it consider the elimination of negative or positive cash flows that would absolutely impact the overall profitability of the investments.

In summary, while IRR is a useful measure, but it is also important to consider its limitations and use other evaluation methods in conjunction to make well-informed investment decisions.

What does it really mean to you as an individual investor?

When an investment gives you an IRR that is lower than the inflation rate, it means that the real value of your investment is decreasing over time. Inflation refers to the general increase in prices of goods and services in an economy over time. If the IRR of your investment is lower than the inflation rate, it means that the growth in the value of your investment is not keeping pace with the rising prices of goods and services. This can result in a loss of purchasing power, as the value of your investment does not increase enough to compensate for the higher prices of goods and services due to inflation.

For example, if the inflation rate in India is 7% and your investment is fetching you an IRR of 8%, it means that the real value of your investment is growing by 1% after accounting for inflation. In other words, your investment is outpacing the rate of inflation by 1%.

You can consider this a positive outcome because it indicates that your investment is providing a return that exceeds the erosion of purchasing power caused by inflation. By earning an IRR of 8%, you are able to preserve and potentially increase the real value of your investment.

It is always a good idea to get savvy and take the time to learn about various investment instruments, strategies, and financial concepts. The more knowledge you have, the better equipped you'll be to make informed decisions. Consider consulting with a financial advisor who can provide personalized guidance based on your individual circumstances and goals.  

Hi. I am an independent Financial Advisor and Authorized Distributor of Mutual Funds in Pune City. My job is to help create wealth for the investors. If you are a new investor, I will do the research, investment, and tracking of your investment to make the process smoother, and help you put your investment objectives in perspective. 

If you like this blogpost and are interested to know more about insurance, do call me or WhatsApp me on +982 230 7712 or email me on smita@ginnsardonic.com. My role extends beyond simply selling investment products. I assist individuals and companies in finding the most suitable investments for their personal needs, homes, businesses, and families.