When you want to evaluate your investment’s return and your earnings from an investment, do not rely on the yield that a product displays.
Instead, do a bit of homework, either yourself or through your adviser’s help, and try to find out the internal rate of return, or IRR, of that investment. Here is why.
Yield versus IRR
The yield of an investment will tell you at what rate money has grown from time A to time B. An annual yield of 7%, for example, means that Rs1,000 at the start of the year has grown to Rs1,070 at the end of the year. This is a simple calculation. It will not be able to help you evaluate a stream of investment cashflows.
Now let’s say you want to measure whether your annuity performed better than your systematic investment plan (SIP), or if the investment you made in a property 10 years ago was better than the equity investments you made in the same period. Just doing a start-to-end yield calculation in such cases will not be fruitful because it is likely that cash inflows and outflows have occurred at various points during the 10 years.
In comes IRR. This will measure the rate of return for a payout made either once or at defined equal time periods, once the potential inflow (value) at the time of sale of the asset is known.
IRR is most useful when investments are made at regular intervals. Compare a Rs10,000 monthly SIP which gives you Rs1.30 lakh at the end of a year, to a semi-annual investment of Rs50,000 which gives Rs1.10 lakh at the end of a year. In both, you gain Rs10,000, but the IRR of the monthly SIP at 15.7% is superior to IRR of 13.5% of the latter. Remember that IRR is an annual calculation and needs to be adjusted for short-term cashflows.
No matter what the underlying asset is, you can use this method to determine the efficiency of your cash outflows or investment and the cash inflows or returns made in that as compared to another.
Irregular cashflows
What happens if you invest irregularly, and make redemptions in between. In such cases one has to use the XIRR formula which measures returns for irregular cashflow of different amounts by taking into account the time period or date when each cash flow was made. But the basic underlying logic remains the same.
Both these formulas are inbuilt in Excel and help you assess returns not only on individual assets but also on portfolio returns efficiently.