Online Investing: Some Mechanical Problems with the IRR

Online Investing Now that you understand the basic logic of the IRR tool, you should know that the IRR, for all of its usefulness, isn’t flawless. Quicken (and every other investment record-keeper’s computer program) calculates a daily IRR and then multiplies this percentage by the number of days in a year to get an equivalent annual IRR.

This sounds right, but it presents problems in the case of publicly traded securities because a short-term percentage change in a security’s market value—even if modest—can annualize to a very large positive or negative number. If you buy a stock for $10 1/8 and the next day the stock drops to $10, the annual return using these two pieces of information is a whopping –98.9 percent!

If you buy a stock for $10 1/8 and the next day the stock rises to $10 1/4, the annual return using these two pieces of information is an astronomical 8,711 percent. To minimize the problems of annualizing short-term percentage changes, you probably want to refrain from measuring IRRs for only short periods of time.

An annualized daily return can be very misleading. One other thing to note is that the IRR calculation becomes more difficult when you try to calculate the average annual profit percentage, or IRR, for a series of years when the starting value is changing from year to year.

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