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Hi, Pixie!

You and I would agree on the return from an investment in a particular piece of rental property, since we would both use the IRR method for that situation. This is because the cash flows are a property of the rental property rather than of the investor; e.g., you cannot choose to pay twice as much in taxes just because you get a bonus you want to invest. But when the portfolio is an open-ended mutual fund OR ITS LOGICAL EQUIVALENT, then I believe that cash flows are irrelevant to the concept of the "performance of the portfolio" per se (though, as you rather emphatically pointed out, not to how much money a particular individual ends up with).

As to the "nonsensical statement," it is clear that we have different concepts of what the "performance of the portfolio" means, and thus we come to different conclusions. This does not mean that my concept is right and yours is wrong, or vice versa, just that we work with different definitions.

Say a friend asks me for help in designing a low-maintenance equity portfolio and I suggest 50% Vanguard 500 Index, 25% Vanguard Extended Market Index, and 25% Vanguard International Value, rebalancing each July 1. My friend may ask what his return from this portfolio would have been for the past 5 years. I can answer the question without first asking what his various additions and subtractions would have been, because I feel the SEC method gives the right answer to that question. This investment strategy is the logical equivalent of an open-ended mutual fund. You need that additional cash-flow information before you can answer the question, because your concept of the "return from a portfolio" is different from mine. Of course, I would also need to have the cash-flow information to tell my friend how many dollars he would have ended up with, but I see that as a different question from the "return from the portfolio".

KEY EXAMPLE

Perhaps the best way to see how our understandings differ is by looking at the basic example I gave earlier: Say you have a portfolio (e.g., an open-ended mutual fund) you invest in over a 2-year period. Say it loses a quarter of its value in the first year but doubles in value the second year. So the SEC and I calculate a 22% Average Annual Return on the mutual fund over the 2 years.

Now say X comes along and claims the mutual fund made him an average of 31% in that 2 years. I ask him how he comes up with such a high number, and he says he invested 10K in it, but after 1 year he added 3K to his investment, and thus had 21K at the end of 2 years; the XIRR function gave the result 31% for these numbers (though he has no idea how it came up with that number).

I point out to him that he only had 10K in the portfolio for 2 years and it made 22% like I said, not 31%; but the 3K he added made 100% for the 1 year it was in. How can he say that the PORTFOLIO's return was 31% for the 2 years by including the 3K that wasn't even invested for the 2 years? Neither of his two investments actually averaged 31% anyway; one averaged 22% and the other averaged 100%.

Then Y comes along and says that he averaged only 11% in that SAME mutual fund according to the XIRR function, though he also started with 10K in it. It turns out that he withdrew 40% of the value of the mutual fund at the end of the first year, and thus he ended up with only 9K after 2 years. I point out that he only had 6K in the mutual fund for the whole 2 years, and that 6K in fact averaged 22%. But he had 4K in the portfolio for only the first year, and THAT 4K lost 25% for that 1 year.

It seems to me that the PORTFOLIO averaged 22% for the 2 years, and thus any amount that was IN the portfolio for the whole 2 years averaged 22%. Amounts in the fund for a part of the time did not of course average 22% for the 2 years, because they were not IN there for the 2 years.

You said, "What kind of a nonsensical statement is that? Of course people are going to have different results in their own portfolio. Returns are contingent on when money is deposited and removed." We agree that X's end result ($21,000) from this portfolio was different from Y's end result ($9,000) from the same portfolio because they had different cash flows in and out of the portfolio. But it seems to me that it is legitimate to say that the PORTFOLIO's return was the same in both cases, because it was the same portfolio.

If you still disagree, then I cannot prove you are wrong, because it is a matter of opinion, not fact.

Bill


P.S. There was nothing in my post that claimed that computing the SEC method by hand is faster than computing the IRR method by spreadsheet. If I enter the data for 52 weeks in my spreadsheet, I get the SEC answer just as fast as the IRR answer, no faster and no slower. In that sense, the two methods are equally easy to apply -- as long as you have a spreadsheet set up for them.

But if one does NOT have a spreadsheet to do the hard work, then the SEC method is simpler in this sense: I can compute the SEC answer for 52 weeks of data by hand in 10 minutes; I don't know anyone who can compute the IRR answer by hand in under half-an-hour. And most investors can learn to calculate the SEC method by hand in just a few minutes, but I doubt that many of them can learn to calculate the IRR method by hand at all.

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