If you’re thinking about investing your hard-earned cash, you’ll quickly come across two key metrics that you may not initially understand: internal rate of return (IRR) and annual rate of return. Both are essential to understanding the performance of an investment, but they’re not the same thing.
I was recently a guest on the Westside Investor’s Podcast where we discussed this exact topic, and in this post, we’ll take a closer look at the differences between IRR and annual return so you can make more informed investment decisions.
Let’s get started.
First, Let’s Define All This Mumbo-Jumbo
First things first, let’s define the terms.
Total return is a simple percentage that shows you how much your investment has grown or declined from the beginning to the end. It’s calculated by dividing the final value of your investment by the initial value, subtracting 1, and multiplying by 100 to get a percentage.
Annual rate of return is a simple percentage that shows your average annual return as if you earned the return equally over the period you owned the asset. It is calculated by dividing the total return by the number of years the asset is held.
Internal rate of return (IRR), on the other hand, is a more complex measure of an investment’s performance. It takes into account the time value of money, which means it considers the fact that a dollar earned in the future is worth less than a dollar earned today due to inflation. IRR is the discount rate that makes the net present value of an investment’s cash flows equal to zero.
In simpler terms, IRR gives you an idea of how much your investment will be worth in the future, taking into account the time value of money.
Now, It’s Time to Make Sense of It All
Now that we’ve defined the terms, let’s talk about the differences between IRR and annual return.
The key thing to remember is that annual return is a simple measure of an investment’s growth over a given period of time, while IRR takes into account the time value of money and gives you an idea of how much the investment will be worth in the future.
Another important difference is that IRR takes into account the timing and magnitude of cash flows, while annual return does not. If the investment has a higher return in the fifth year than in the first year, then IRR takes this into account and gives a more accurate picture of the investment’s performance.
Finally, it’s worth noting that IRR is more complicated to calculate than annual return. With annual return, you can simply divide the total return by the initial investment and express it as a percentage. With IRR, you need to use a financial calculator or a spreadsheet program that has the capability to perform iterative calculations.
Which Metric Should You Use When Investing?
So at the end of the day, which one should you use?
Well, it honestly depends on the investor, the type of investment, and your investment goals. If you are sensitive to the fact that an investment has varying cash flows and you care that some of those cash flows don’t occur until later in the life of the investment, then use IRR.
If, instead, you aren’t concerned about the timing of those cash flows, then use the simpler Annual Return In the end, the choice between using IRR or annual return comes down to what you are comfortable with.
Understanding these two metrics can help you make more informed investment decisions and ultimately achieve your investment goals.
And on that note, I’ll leave you with a little joke: Why did the investor break up with his calculator? It could only give him simple interest, but he was looking for a more complex relationship. Ha!
In all seriousness, I hope this post has been helpful in explaining the difference between IRR and annual return.
To learn more about how multi-family real estate investing can increase your family’s investment portfolio as a passive investor, click here to listen to the full Westside Investor’s Podcast!
Disclaimer: This is not an offer to buy or sell any security.
All investments involve risk and may result in partial or total loss. Past performance is not indicative of future results. Any historical returns, expected returns, or probability projections may not reflect actual future performance. Prospective investors should carefully consider their investment objectives, risks, charges and expenses, and should consult with a tax, legal and/or financial adviser before making any investment decision.