metrics explained

Average return vs Internal rate of return: What's the Difference?

When it comes to investing, there are a lot of different ways to measure success. Oneof the most common ways is to look at the return on investment (ROI). Thisis the percentage of the original investment that is earned back over thecourse of the investment. For example, if you invest $100 in a stock andit goes up by 10%, your ROI would be 10%.

However, ROI is just one way to measure the performance of an investment.Another common metric is the average return. The average return is simplythe average of all the periodic returns that an investment generates. Forexample, if you invest in a stock and it goes up by 10% in year one, downby 5% in year two, and up by 15% in year three, your average return wouldbe (10+(-5)+15)/3, or 5%.

Average return is a good metric to use if you're looking to comparedifferent investments. However, it has its limitations. One of thebiggest limitations is that it doesn't take into account the timing ofthe returns. For example, in the above example, the 10% return in yearone is worth more than the 15% return in year three because it was earnedearlier. This is where the internal rate of return (IRR) comes in.

IRR is a metric that takes into account the timing of the returns andgives a more accurate picture of an investment's performance. In theabove example, the IRR would be higher than the average return becauseit would take into account the fact that the 10% return was earned inyear one.

IRR is a more accurate metric than average return, but it's also morecomplicated to calculate. As a result, it's not always used by investors.However, if you're looking to get a more accurate picture of aninvestment's performance, IRR is the metric you should use.

How to Calculate Average Return

Calculating average return isrelatively simple. All you need to do is take the sum of all the periodicreturns and divide it by the number of periods. For example, if you havea stock that goes up by 10% in year one, down by 5% in year two, and up by15% in year three, your average return would be (10+(-5)+15)/3, or 5%.

How to Calculate Internal Rate of Return

Calculating IRR ismore complicated than calculating average return. The first step is todetermine the cash flows for the investment. Cash flows are simply theinflows and outflows of cash that are associated with the investment.For example, if you invest $100 in a stock and it goes up by 10%, yourcash flow would be $10 (the 10% return on the $100 investment).

Once you have the cash flows, you need to discount them. This isbecause, as we mentioned earlier, the timing of the cash flows isimportant. The further in the future a cash flow is, the less it's worthtoday. For example, a cash flow that will be received in 10 years is worthless than a cash flow that will be received in one year. The reason forthis is that there's a risk that the cash flow will never be received, orthat it will be worth less in 10 years than it is today.

The discount rate is the rate at which you discount the cash flows.This is usually the same as the investor's required rate of return.Once you have the discounted cash flows, you can then calculate theIRR. This is the rate at which the present value of the cash flows equalsthe original investment. In other words, it's the rate at which theinvestment breaks even.

Calculating IRR is a more complicated process than calculatingaverage return. However, it's a more accurate metric, which is why it'spreferred by many investors.

The Bottom Line

When it comes to measuring the performance ofan investment, there are a few different metrics you can use. ROI is acommon metric, but it has its limitations. Average return is a goodalternative, but it doesn't take into account the timing of the returns.IRR is a more accurate metric, but it's more complicated to calculate.As a result, it's not always used by investors. However, if you'relooking to get a more accurate picture of an investment's performance,IRR is the metric you should use.

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