Someone recently asked me what risk statistics should be used with the internal rate of return (IRR), (which, as any reader of this blog knows, is my preferred return measure). Sadly, I didn’t have an immediate reply.
The plethora of risk statistics that are available for time-weighted rates of return (TWRR) use the intra-period returns. For example:
- standard deviation (we can continue its appropriateness as a risk statistic)
- tracking error
- downside deviation
as well as the multitude of risk-adjusted return measures that use these risk measures (such as Sharpe ratio).
Recall that the IRR measures the return for a single period; there is no linking. Comparing the portfolio’s IRR with the benchmark’s only serves the purpose of seeing how well the portfolio did. But how can we measure risk if we use the IRR?
Reflect on this for a bit; I will return to this matter soon, with some concrete ideas.