Financial Planning & Investing using Quicken Software: Stephen Nelson, CPA

Understanding Quicken's Annual Return Calculations

If you're an active investor and you use Quicken for your investment record-keeping, you may wonder about Quicken's annual return calculation, which appears on some of the Quicken investment reports.

Because this return value-technically an internal rate of return-is complicated to calculate and potentially misleading, let briefly describe why Quicken (and you) may want to use the internal rate of return (IRR) tool and how it compares with the other standard performance measurement tools.

What Is an IRR?

The IRR tool calculates the annual profit an investment delivers as a percentage of the investment's value at the start of the year.

For example, in a simple case, if you buy an investment for $100 and the investment pays $10 in dividends at the end of the year and then is sold for $95, your IRR is 5 percent.

There are actually two steps to making this calculation:

You need to calculate the annual profit. You can do this by combining the $10 of dividends with the $5 capital loss (calculated as $95-$100) for a result of $5 of annual profit.
You divide the $5 of annual profit by the $100 investment value at the start of the year. $5/$100 equals 5 percent, and that's the IRR.

By calculating an IRR, you can quantify the performance of a stock that you've purchased and of your investment portfolio as a whole. This is particularly true with individual stocks and brokerage accounts because you often don't really know how your stock picks, your broker's picks, and your portfolio have done and are doing relative to the market as a whole and relative to other investments.

In comparison, you usually have a pretty good idea as to how well a mutual fund does on a quarterly or at least an annual basis. The fund manager will report to you on the quarterly and annual returns.

Some Mechanical Problems with the IRR

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 and an 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 and an 1/8 and the next day the stock rises to $10 and a 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.

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

The problem with an nth degree polynomial is that, by definition, it can have up to n real and imaginary roots, or 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.

If you're having trouble getting Quicken's investment recordkeeping tools to work right, let's discuss your questions next year when I prepare your personal tax return. Alternatively, if it's really important to you to get your questions answered before that, call me to set up an appointment.

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