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6 min read Investing

You cannot pay for coffee using IRR

Percentage returns are irrelevant if the invested amount is small to begin with. Position Sizing matters in wealth creation. What is not very intuitive is that there must be a minimum ticket size for all positions.
You cannot pay for coffee using IRR
Photo by Clay Banks / Unsplash

This was a few years back. I was an early investor in a startup, which had raised a round of funding from a VC investor. I was making many dozen times my initial investment.

Fantastic! I first thought.

But my life did not change much. In fact, I was mildly annoyed by the whole situation.

Now, don't think that I am ungrateful. It was just that the amount I had invested in the first place was so small that the resulting wealth was not life-changing by any means.

Oops!

Percentage returns vs absolute returns

In real life, when it comes to creating wealth, it is the absolute amount of money that we have and the absolute returns that we make that are of consequence.

Absolute Returns  
=
Return %  
X  
Amount invested

In this formula, we tend to be fixated on the return percentage and we hardly ever talk about the right amount of investment.

In some ways, that’s understandable, as people are discreet about revealing their actual wealth — social norms dictate that you never ask someone how much they earn. We tend to abstract absolute amounts when conversing with each other. Percentages come in handy.

I argue that returns percentages and IRR are just a vanity metric. Because you cannot pay for coffee using IRR!

You cannot eat IRR

When a friend tells us, “I just bought a stock that has doubled for me”, before feeling a rush of envy, we need to ask ourselves whether this enterprise has made any significant wealth for them. Is it the case that they invested all their money and doubled it? Or was it $100 in and $200 out?

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