In this article, we shall see how to make sense of your returns number, and how to use it for decision making for the future.
The first step is to ensure the returns you have calculated are clean and accurate. The last thing you want to do is to go on a wild goose chase 'understanding' incorrect numbers! If your number is over 50% or less than -25%, you have very likely missed out some entries. Check that you have included every purchase, every interest earned, every redemption and the market value for each investment within the date range.
In fact, if you have taken data of three years or longer, returns will very likely lie in the -10% to +20% range. In all further discussion below, we will assume you have data for atleast three years. While the method is valid even for a month, results can be volatile if the time period is too short. Taking a longer period is useful in deriving useful insights from the XIRR.
What is the Optimal Range?
If you are in your earning years (say more than a decade away from retirement), a number between 12% and 20% is a good one. This is because you can afford to take more risk during this period. Indeed you should, so that you push your potential upside to the maximum. If you are retired or close to retirement, a number between 9% and 12% is good. You will obviously want to take less risk at this time, and would be satisfied with this smaller (but inflation beating) number.
Obviously these numbers will vary a bit with market conditions. But if you take a long enough time period (minimum three years, but preferably five), you will find these ranges staying more consistent. Lets now look at what deviations from these mean, and what you can do about them.
What Does a Negative XIRR Indicate?
If your number is negative despite taking a 3-year or longer time horizon, it is likely you have made some bad investment decisions. Some common mistakes we've seen include:
Having exit equities in panic during late 2008 or early 2009
The important message here is to stay invested, irrespective of market situation. The other takeaway is to avoid portfolio churning, and avoid products with excessive complexity and cost structure. Mutual funds and front-line stocks should be just fine.
What if My Return is Positive, But Low?
If your number is in the 0% to 7% range, there are two possibilities:
1. Either you have let too much money lie in savings bank accounts (or over-relied on recurring / fixed deposits) without investing them, or
2. You have had a mixed investment performance – some of your hits have balanced losses on other calls
If it is the first reason, you really need to shake off your inertia! Remember, inflation has stayed above 9% for quite some time now, so you have actually eroded wealth. You need to be taking more calculated risk. If you are uncomfortable yourself, funds are a good place to start,
If it is the second, try to identify your mistakes. Markets could have genuinely been bad, or you could have made the same mistakes given above. If you find it difficult to devote more time fine-tuning your investments, or if you don't seem to be picking stocks right, go for mutual funds of the diversified or index variety.
My XIRR is too High!
If you haven't made any mistake in your calculations, too high an XIRR usually means too much risk. You may have hit upon some multi-bagger stock calls, or made quick money in commodities or derivatives. Usually, none of these are sustainable roads to the riches, as you can rarely manage an encore.
To be more sustainable, you might want to shift bulk of your portfolio to more stable funds, deposits and blue-chip stocks. You can always have a small portion allocated to more risky trades and exotic investments. This will ensure you have the potential to earn a little more, without the risk of rocking your basic ship.
Your returns are like your blood pressure/sugar level. Both too high and too low indicate a problem! The important thing is to be periodically aware of the reading, so that you can take appropriate corrective action.
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