Difference Between Internal and External Rate of Return

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Internal vs. External Rate of Return <br><br><br>Do you know the difference between internal (or micro) and external (or macro) rate of return. If not, you are probably losing a lot of money in your retirement planning without even knowing it. Most people tend to focus on the internal rate of return in their portfolio, and completely ignore the much more powerful, much more impactful external rate of return. For retirement planning it is imperative to know the difference, and understand how both types of rate of return fit into your overall financial picture. <br><br><br>To begin, let's get a clear understanding of the definitions of these terms. The internal rate of return is specific to the investment vehicle you are looking at, and only that vehicle. It ignores everything else going on in your life and focuses only on that one vehicle. For example, on your mutual fund statement when you see that your retirement planning fund had an 8 return last year, this is an internal rate of return. That 8 number is simply comparing the retirement plan account balance at the beginning of the year with the balance at the end of the year to see if the mutual fund made any money or not. (You also need to know if this is an actual or average rate of return. Click here to learn more) In contrast, the external rate of return looks at your entire financial picture and puts that vehicle in context with everything else in your life in addition to your retirement planning. It looks at what else that investment allows you to do, or keeps you from doing, in your life because you own it. <br><br><br>Here is a simple example to illustrate the difference. Take a look at your cell phone. What did you pay for it? $100 or so? What will you be able to sell it for later? Probably nothing. In addition to that you have ongoing costs to maintain your calling plan. So how much money does your cell phone make directly? The answer, of course, is nothing. In fact you are losing money because you own the cell phone. So the internal rate of return for that cell phone is negative 100. <br><br><br>Now, what does the cell phone allow you to do, that you could not do if you didn't have it? Obviously there are numerous possible answers to this question. It allows you to conduct business more easily, keep in contact with others faster and more efficiently, keep a calendar, store hundreds of contacts, do business from any location, etc. Having the cell phone allows you to do so much more than not having it. So what is the external rate of return on the phone? Huge! To calculate that first add up all the money you earned from all the business calls you made, quantify and put a dollar amount on the time it saved you and the greater connectedness it provided, etc. then compare that to the actual dollar amount you spent to buy the phone and keep your calling plan. Needless to say, the cell phone probably has a 1,000 or greater external rate of return because of all the things it allows you to do. <br><br><br>Now how do you apply this to your retirement planning? Can you see that in your retirement planning there is much more to consider than simply the internal rate of return in your mutual fund, 401k, pension plan, stock portfolio etc.? For example, does your current retirement plan allow you to live where you want? Will it allow you to live the lifestyle you want? Is it liquid, or are there rules restricting access to your money? Will your retirement plan guarantee you won't run out of money? Will it pass anything along to your heirs? Does your retirement plan keep you from doing some of the things you want to do right now? Can you take the vacations you want, or do you have to stay close to your office to manage it? Is your retirement plan outpacing inflation and other eroding factors? If you become disabled will it still work? If you died prematurely will your spouse's retirement plan still work? Can you leverage your retirement planning investments to make them better or have a higher rate of return? <br><br><br>When you consider questions like this it becomes very clear that the internal rate of return on specific investments in your retirement plan are not nearly as important as how that plan fits into your real life. In fact, it is possible to have a really high internal rate of return, but actually have a negative external rate of return because the plan just doesn't work with the rest of your life. The reverse is also possible. You could have a negative internal rate of return on a particular investment vehicle, but have a high positive external rate of return in your retirement plan because of what that vehicle allows you to do in the rest of your life (i.e. the cell phone example above). <br><br><br>There is a lot to consider in retirement planning. Understanding the difference between internal and external rate of return will help you make better decisions for your retirement plan. By assessing the external rate of return with each decision you will be able to create the life you want to live both now and in retirement.

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