Let’s use XIRR to combat our mental blocks and optimism bias

I have been discussing with multiple people about their investment performance and realize a lot of us have tendency to block out data (esp of ones with unfavorable outcomes) or have an optimism bias of the returns we have generated in the market.

Blocking out is usually manifested as a refusal to critically evaluate the returns our wealth is generating for us. I believe, a subconscious part of us knows that it was a bad decision but, I guess acknowledging it will make it “real”. For example, holding on to the stock which we thought was great but now we know is a dog, or closing out that expensive insurance or investment product we were sold by an “optimistic” sales person.

By optimism bias, I mean, “viewing” (read feeling) the returns on our investments to be greater than they actually are. For instance, reluctance to review the decision to hold on to a stock that hand an extraordinary run after we bought had about 8 years ago and which has stopped performing for the last 3 or 5 years – assuming that with such a run it would be doing well.   Or having a very positive view of the returns that have been generated on the stock or piece of real estate we have been holding for 20 years.

XIRR is a simple formula in Excel that gives annualized return of an individual investment or a portfolio over the period of our investment. This will give us a very quick reference about whether we would have been better-off parking the funds in Bank FD or in the market index (based on individual risk appetite). If we see that our assets are generating better returns than the identified benchmark (FD or market index), we can return to our merry ways; if that is not the case then this could be a point where one can reflect on the next steps.

A fair expectation should be that the assets we have should be generating better than inflation rate of return – which should be bank FD rate or market index rate.

I think a yearly review of the returns generated by our portfolio of assets is a good practice and will help bring a reality check to our assumptions.

Here is the example of XIRR

Hope this helps review whether the money you made is working for you.

Happy investing…..

 

PS: A great TED talk by Tali Sharot on optimism bias

About praveen

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3 Comments

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  1. sathish kandhaswamy says:

    Hi Praveen,

    How are you? . I’m trying to use XIRR function to evaluate a Insurance plan. On the XIRR function, i see a guess value. What is a guess value? when does it changes ?

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