“What’s your investment return?”
It’s a simple question, but there are multiple ways to answer it. That’s because there are four primary methods of calculating investment return. They are:
- Simple return
- Time-weighted return
- Money-weighted return
- Internal rate of return
Each method was created to measure a particular aspect of an investment’s performance. You might assume they’re all closely related (after all, they all have the word “return” in them), but you’d be wrong. In reality, they can yield very different results.
Here we’ll go over each kind of return and explain what it measures and why you might (or might not) want to use it.
Simple return (SR)
What it measures: Simple return is your portfolio’s total net gain divided by net contributions. This is the most common “back-of-the-envelope” math people use when they scan their statements, largely because it’s so easy to calculate.
Unfortunately, this kind of return is often the most misleading. Simple return weights all deposits and withdrawals equally dating back to whenever you opened the account. As a result, a large, late addition of cash can massively reduce the return of an account or mask losses in that account. Ironically, a late withdrawal will swing the simple return the other way.
When to use it: Ideally, never. Because late deposits and withdrawals impact simple returns so much, it’s almost never a good way to compare investment managers or your portfolio’s performance.
Time-weighted return (TWR)
What it measures: Time-weighted return compounds your account’s daily returns from the time it was initially funded up until the present. It doesn’t factor in the timing of any deposits or withdrawals.
When to use it: We believe time-weighted return is the right way to evaluate an investment manager because it represents a true reflection of how your money has been managed (rather than how your contributions and withdrawals affected your performance). After all, an investment manager usually won’t have control over when you deposit or withdraw cash, so it makes sense to use a measure that doesn’t account for those factors.
Money-weighted return (MWR)
What it measures: Money-weighted return compounds your daily returns and weights them according to the amount of money that was invested each day. Another way of saying this is that MWR is the rate of return that will cause the net present value of your portfolio’s cash flows (deposits and withdrawals) and terminal value to equal the value of your initial investment.
Interestingly, MWR and TWR converge over time if you make frequent deposits.
When to use it: MWR isn’t a good way to compare two investment managers unless you made identical deposits and withdrawals to the accounts you’re comparing. It can be a good measure of a single investment manager’s performance if the manager has control over the timing of all of your cash deposits and withdrawals.
MWR can be helpful as you consider how your portfolio has performed relative to your financial goals. You can also use MWR to evaluate how good you are at timing the market, but there are seldom enough data points for the results to be statistically significant. Research which looks at very large data sets consistently shows that even professional investment managers aren’t good at timing the market.
Internal rate of return (IRR)
What it measures: Put simply, IRR is MWR that’s been annualized. For example, if your account has been managed for six months and has a MWR of 3.92%, your IRR would be 8% (slightly more than double the MWR because of compounding).
When to use it: IRR is most often used to evaluate private equity funds because they have many deposits and withdrawals, all of which are under the control of the fund manager. IRR can be an effective way to compare investment managers, but only over very long periods of time. In the short term, volatility can distort IRR.
Where things get confusing
Many people are surprised to learn that one method of calculating return can lead to a positive outcome when an alternative approach yields a negative result and vice versa. This is usually caused by the impact of fluctuating markets on cash inflows and outflows.
For example, let’s say you initially deposit $10,000 in your account and it doubles in one month. Then you deposit $100,000 and the market drops 25% the following month. Your time-weighted return would be +50%, your money-weighted return would be -31%, and your IRR would be -89%.
In this example, your investment manager invested well, but you timed the market poorly. Using money-weighted return would unfairly make the investment manager look as though they performed badly when the return was most influenced by your unfortunately timed deposits.
Use the right return for the right job
So where does this leave us? Here’s your cheat sheet:
Simple return: Don’t use it.
Time-weighted return: Use it to track the performance of an investment manager when you, not the manager, control contributions and withdrawals from the account.
Money-weighted return: Use it to evaluate how your portfolio has performed relative to your long-term financial goals.
IRR: Use it to track the performance of an investment manager when the manager controls contributions and withdrawals from the account, preferably over a long period of time.
Return calculations are ultimately just a tool to help you understand how your investments are doing. By understanding the different kinds of returns, you can ensure you pick the right tool for the job – and make informed decisions so you can grow your long-term wealth.
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