Understanding your returns - video

We’d like to talk to you about investment returns.

There are different ways to calculate investment returns, and we’re going to compare two of the most common calculations and explain where each is appropriate. These are the time-weighted rate of return and the money-weighted rate of return, sometimes referred to as the dollar-weighted rate of return.

The time-weighted rate of return considers only the change in the investment’s market value over a specific period of time.

The calculation isolates the portfolio’s performance and reflects the decisions made by the portfolio manager over the period.

It is useful for comparing the performance of your investments to other investments, like mutual funds over a period of time.

A time-weighted rate of return is not affected by your personal contributions or withdrawals from your account. 

The rates of return reported on a mutual fund company website use a time-weighted rate of return calculation.

The second calculation is the Money-Weighted, or dollar-weighted Rate of Return. Unlike the time-weighted rate of return, it includes the effect that the timing and amount of your contributions and withdrawals have on your investment returns giving you a more personalized view of your investment portfolio.

It’s important to note that in the absence of cash flows, the money-weighted rate of return is equal to the time-weighted rate of return.

It’s also important to note that time-weighted and money-weighted rates of return are both valid measures of investment performance.

Time-weighted is most helpful when comparing different investment alternatives; Money-weighted provides a snapshot of an individual’s return, reflecting their actual investment experience.

Here are some examples to show how the two return calculations work. 

Let’s say that you invest $100,000 in a portfolio on January 1st. That’s your only investment for the year. By December 31st, your $100,000 has grown by 6% to $106,000, so your time-weighted rate of return for the year is a gain of $6000 – divided by your investment – one hundred thousand dollars, or six percent.

Since you didn’t touch your portfolio since your initial one hundred thousand dollar investment, 6% is also your money-weighted rate of return. There is no difference between Money-weighted rate of return and time-weighted rate of return in this case.

Now, let’s look at a second situation where you still invest your $100,000 at the start of the year, but you also invest an additional $100,000 at mid-year. At the end of the year, your portfolio is now worth $209, 921

Because your time-weighted return doesn’t factor in your second contribution of $100,000, it is still 6%.

But, here’s something interesting: you had $100,000 in the account during the first half of the year, plus the gains that were building up. So, just before you made your second contribution, your portfolio was worth $102,000. When you added $100,000 to that, your total holdings were worth $202,000.

So, after your contribution, you had $202,000 invested in your account.  In the money weighted calculation, the second half of the year would carry more weight because there is more money being affected by the portfolio’s performance in the second half of the year. As it happens, over the second half, the portfolio had stronger performance. It was up by an additional 3.9%. This difference is taken into account in the money-weighted rate of return calculation. So, your money weighted rate of return is 6.63%.

So, let’s sum up.

There are two primary and valid measures of investment performance. A time-weighted rate of return removes the effect of your contributions and withdrawals on investment returns. It measures the performance of the market value of an investment over a period of time and it’s used to gauge the portfolio manager’s decision-making and performance. And it can help you compare the performance of one investment to another.

A money-weighted rate of return factors in performance AND the impact of YOUR cash flow decisions, providing you with an indication of YOUR personal rate of return. 

Thanks for watching.