Average Rate of Return vs. Internal Rate of Return

Key Takeaways

• Return on investment shows the percentage increase or decrease of an investment, however it fails to consider the time factor.

• Average rate of return takes the time factor into consideration, but does not consider costs associated with an investment. 

• Internal rate of return considers timing and costs, which makes it a more accurate metric, however its calculation is also the most complicated.

The whole point of investing is to achieve a return on that investment.  While there are a few different methods by which to measure that return, the most common are return on investment, average rate of return and internal rate of return. This article will define those terms, illustrate how they’re calculated and offer examples of each. 

What is Return on Investment (ROI)?

An ROI calculation shows the percentage of the initial investment amount returned over the entire duration of a venture. For example, $1000 invested in a stock, which is later sold for $1,100, can be said to have returned 10%. 

Thus, the ROI for that venture is 10%

However, investors must consider all of the costs associated with that investment to get an accurate accounting. Taxes, fees, carrying costs and the like can detract from the profit achieved when an investment is sold. Therefore, all of those expenses must be taken into consideration when any true measurement of the current value of an investment is calculated.

Moreover, ROI only considers the total change in value of an investment over its holding period. Say for example, a stock is purchased for $100 and later sells for $1000, that return looks phenomenal, until you learn it took 100 years to achieve it. 

This is where the average rate of return comes in.

What is Average Rate of Return?

Typically employed to compare investment opportunities, the average rate of return, as the term implies, is the average of the periodic returns generated by an investment. Say for example a three-year $100 investment gains 10% in its first year, loses 5% in the second year and gains 15% in its third year.

The formula for calculating the average rate of return over that three-year period would be:

(10+ (-5) + 15)/3 = 6.6% 

The average rate of return of that investment is 6.6%

As mentioned above, this can be useful for comparing investments. However, it has one rather significant failing. It does not consider the time value of money. After all, a dollar earned today can be worth more than a dollar earned tomorrow — because today’s dollar has greater earnings potential than one earned tomorrow when it is reinvested. 

Which brings us to internal rate of return (IRR).

What is IRR?

This metric provides a more accurate picture, as it calculates the annualized percentage of return — including associated costs — over any given duration of an investment. In other words, an IRR calculation will tell you the annualized percentage returns of an investment over any period of time, while taking associated costs into consideration.

For example, the IRR on a one-year investment is identical to the ROI. After all, any investment must earn 50% in order to grow from $50 to $75 over a one-year period. However, when calculating an annual return over a multiple year period, things become a bit more complicated. 

This is particularly true when taxes, fees, dividend payments, and other cash expenses or gains are folded into the equation. The good news here is Excel spreadsheets are capable of making these calculations automatically. 

However it is useful to understand how it works just the same. 

Consider a four-year scenario in which a $100 investment is made. The first year, that investment incurs a $5.00 brokerage fee, which means the investor’s net cash flow in the investment at the end of the first is -$105 — assuming no gains. At the end of each of the second, third and fourth years, the investment pays dividends of $5 each, for a net cash flow of $5 each year. The investment is then sold at the end of the fourth year for $165, incurring another brokerage fee of $5 and taxes of $13, for an actual return of $52 on the $100 investment.

Net cash flow at the end of the first year is -$105, $5 at the end of the second year, $5 at the end of the third year and $152 at the end of the fourth. Thus the internal rate of return over the four years of this investment is 16.2% and the ROI is 57%.

Again, the ROI is the simple percentage gain, while the IRR represents the average annualized return after taking associated costs into consideration. 

Why This Matters to Investors

Each metric has useful applications for investors, whether considering stocks, bonds, hedge funds, real estate or other investment vehicles. However, the IRR can help investors more accurately measure the performance of an opportunity over the long term against benchmark indexes. 

This is because the performance of an opportunity is defined in consistent annualized terms.  However, an ROI calculation can be useful for illustrating short-term gains and cash on cash returns in a much simpler fashion. 

Return Metrics, Portfolio Diversification and Alternative Investments

Of the three metrics considered here IRR and ROI are the most useful for investors when considering the potential of an opportunity. ROI will reflect the total growth or loss over a specific period of time, while IRR indicates the annual expected return. 

Which of these metrics offers more value depends upon the overall objectives and the time horizon of the investor.

Portfolio diversification can also offer significant value when considered in conjunction with those factors. Seasoned investors understand the benefits of spreading their investments over a variety of asset classes to try to mitigate market volatility. Alternative investments can be a good way to help accomplish this too. 

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember alternatives can also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

Today, platforms like Willow Wealth provide curated access to private markets for individual investors.   

Investors can get started with minimum investments as low as $5,000 for their first investment (subject to certain exceptions). Willow Wealth offers a curated selection of opportunities across multiple asset classes, ranging from individual investments to diversified funds and automated portfolio solutions. While these investments carry risk, they open the door to opportunities across real estate, private credit, private equity, and more.  

Join more than 500,000 members and start investing in private markets today at willowwealth.com. 

In Summary

When all is said and done, each metric has specific benefits. The IRR provides more information for long-term investors or when considering the performance of an investment against a benchmark such as the S&P 500.  Meanwhile, short-term investors, or those simply interested in cash on cash gains will find an ROI calculation adequate — and easier to calculate.