IRR: A widely used measure of investment performance. Internal Rate of Return is the discount rate at which future cash flows, discounted back to the present, equal the purchase price. Implicitly, IRR assumes that every distribution that is received is reinvested at that IRR rate. High early cash flows set the IRR to a high level, which in turns means that all intermediate distributions are assumed to be re-invested at the unrealistically high rate, making IRR unrealistically high and sticky (IRR does not change much irrespective of what happens to investments after some time). Similarly, if initial investments do not do well, IRR will be negative and then imply that all intermediary distributions are burnt at the same rate each year (some capital is destroyed as it is assumed to be re-invested at a negative rate), leading to a misleading low IRR. In practice, and for some mysterious reasons, practitioners recognize the IRR problem when it is negative and never report a negative IRR. Instead, they rightly report ‘not meaningful’. However, when IRR produces a similarly unreasonable re-investment rate (say 30%), many advertise it very loudly.
