Need to Know: Annualized Returns Versus Internal Rates of Return

Let’s start with annualized returns (ARR). The annualized rate of return represents the average yearly return you would have received over a specific period. It takes into account compounding, assuming that the investment grew steadily each year, even if the actual returns varied. This differs from the average rate of return, which simply calculates the simple average over a period. For example, if an investment grew by a total of 18% over three years, the average rate of return would be 6%. However, when expressed as an annualized return, it would be 5.6%, reflecting the impact of compounding. We use annualized rates of return to compare different investments and asset classes. Remember that past annualized rates of return do not guarantee future returns.
Now let’s discuss internal rates of return (IRR). IRR considers the timing and amount of cash inflows and outflows, as well as the time value of money (inflation). This provides a more comprehensive measure of investment performance. To understand IRR, consider the investments underlying a Living Annuity. A portion of the investments is allocated to conservative funds to cover cash outflows during retirement, while the remaining balance is invested in growth-oriented funds to account for longevity. The inflows include compound interest from reinvested dividends, while the outflows represent the regular payments received during retirement. Calculating IRR can be complex, but our experts have the tools and expertise to provide accurate figures. IRR is generally used when an investment involves multiple periods of cash outflows and more complex cash flows.
In essence, ARR and IRR measure the same thing but from different perspectives. ARR represents the return earned by a theoretical investment that remained invested throughout the entire period, while IRR measures the actual return earned by the portfolio, considering the specific cash inflows and outflows. Annualized returns provide a high-level, generic number, while IRR offers a specific calculation tailored to your investment. If you made a lump sum investment and left it untouched for a period, your annualized return and IRR would be the same.
We are here to simplify your investment strategy, considering your evolving goals, market conditions, and varying rates of return. If you need further explanations or have any questions, please don’t hesitate to contact us.
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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