Online Investing: Some Mechanical Problems with the IRR Part (2)

Online Investing The basic problem is that the IRR formula is what’s called an nth root polynomial (n is the number of days in the IRR calculation).  A one-year IRR calculation is a 365th root polynomial. (Remember that Quicken calculates daily IRRs and then annualizes these daily percentages.)

The problem with an nth root polynomial is that, by definition, it can have up to n real and imaginary solutions. An annual IRR calculation could theoretically have 365 correct IRRs. You would not normally have this many solutions, but you could still have several correct solutions.

So you can see that by using IRR-based return calculations, there’s an opportunity for real confusion. Quicken, recognizing these problems, does not attempt to calculate IRRs for investments that look like they may have more than one IRR. You’ll know for which investments you can’t calculate an IRR, but you won’t know how those investments did.

Summary

For investors with large portfolios, online investing offers big benefits. Investment costs often decrease, and investment record-keeping often becomes simpler. In some cases, investment decisions may even get better because of access to better information. Online investment tools, however, can be tricky use—especially as you start.

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