What Exactly Is IRR? Explaining Internal Rate Of Return
My Wife Insists You Don’t Understand Me
My wife keeps telling me that no one understands me.
Maybe she has a point.
When making an investment recommendation to you, I reference something known as Internal Rate of Return… or IRR.
It’s a tool for analyzing and comparing different opportunities.
I get that most people aren’t familiar with the idea of IRR… and even many who have encountered it don’t really understand what it is or how it works.
Fair enough.
However, if you’re going to make an investment projecting irregular cash flows over multiple years, you need to get your head around IRR. It’s the only way to effectively size up one opportunity versus others you may be considering.
Misunderstanding IRR
A reader wrote me this week to say that she’s disappointed with an investment she has made on my recommendation. The investment, as I’ve reported, projects a 14% return… but she’s getting only 10%.
The problem isn’t the return. The problem is a misunderstanding to do with the return projection.
The investment projects an IRR of 14%. That does not mean the investment will return 14% every year.
In fact, this investment projects 10% yields in the first year or two (which is, indeed, playing out to be the case)… with yields growing over the 20-year lifespan of the investment. The 14% is the IRR… over the 20 years.
Taking into account zero cash flow periods at the start and lesser cash flow periods early on.
Make sense?
If not, please get in touch here so we can discuss further.
Seriously. I love to talk about this stuff.
Lief Simon
