“Returns matter a lot. It’s your capital.” (Abigail Johnson)
Let’s start at the beginning – Annualised returns
The annualised rate of return on investment represents the average yearly return you would have received over a specified period. It expresses an investment’s performance as if it had grown steadily each year, taking compounding into account, even though the actual returns may have varied per year.
This is different to the average rate of return, which would just show a simple average over any period.
For example, if an investment grew by a total of 18% over three years, the average rate of return would be 6%. However, expressed as an annualised return, it would be 5.6%, showing the impact of compounding.
We use annualised rates of return to compare diverse investments and asset classes. Remember that that past annualised rates of return do not guarantee future returns.
Upping the ante – Internal rates of return
Internal rate of return considers the timing and amount of cash inflows and outflows, as well as the time value of money, providing a more comprehensive measure of investment performance.
One of the easiest ways to understand the internal rate of return is to consider the investments underlying a Living Annuity. It’s standard practice to invest a portion of the investments into conservative funds to provide for the drawdowns (cash outflows) from the investments. The balance of the investments is allocated to funds which provide growth (over and above inflation) to account for your longevity.
The inflows into a Living Annuity include compound interest (growth on growth as the dividends of the long-term investments are reinvested), and the cash outflows are the amounts you receive monthly (or annually) to provide you with an income during retirement. (You can draw between 2.5 and 17.5% of the retirement investment annually.) The investment period is usually the difference between your current age and 95.
Working out the IRR is quite tricky, but we have the tools and expertise to provide you with the figures. We generally use internal rates of return when an investment involves more cash complex cash flows, including multiple periods of cash outflows.
What does it all mean?
When it comes down to it, ARR and IRR are measuring pretty much the same thing. Their reference point is just different. With an annualised calculation, you are measuring the return earned by a theoretical investment that stayed invested through that entire period. With IRR, you are measuring the actual return earned by the portfolio.
In other words, annualised gives you a high level, generic number. IRR gives you a specific calculation for your money. If you were an investor who put in a lump sum at the start of a period and didn’t touch it, your annualised return and IRR would be exactly the same.
Let us do the worrying
The bottom line is that we’re here to simplify your investment strategy, considering your ever-changing goals, market conditions and varying rates of return. Please feel free to contact us if you’d like any further explanations.
Disclaimer: The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.
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