“SO, HOW DID I DO?”

Posted on August 30, 2012

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Part I: Time Weighted Return vs. Dollar Weighted Return.

As we approach the end of the quarter, soon we will be mailing out our Enhanced Quarterly Report. This document presents you with the detailed breakdown of your investments and is designed to answer a very basic question: how did your investments perform and how are you doing in achieving your financial goals”

The answer to this question is not as easy as it first may seem. In the past we received questions from our clients who were confused about the numbers they saw. In particular, they questioned how is it possible that sometimes they see negative percentage returns, while the account value is clearly up? How is this possible? In this post we will try to answer this question with an example and illustrate the right way to gauge your investment performance.

The answer lies in distinguishing between Time Weighted Return (TWR) vs. Dollar Weighted Return (sometimes known as an Internal rate of return or IRR). While TWR does not take into the account the timing and size of the cash flows, the IRR does. The difference may seem subtle, but as you will see from the example below, it can be very meaningful.

Lets take a an investor, who decides to buy the shares in the ABCDX fund. On January 1, the share of the fund is worth $100. Shortly after the beginning of the year, the price of the share drops to $80 and investor decides to sell:

The market continues to do poorly, and shares decline further to $40 per share. At this point, the investor looks at ABCDX and decided that it is a good bargain at that price and reinvests his $80, buying 2 shares of ABCDX, now at $40 each.

The market then reverses its decline, and the shares of the fund rally back to close the year out at $80 per share. It is now December 31st and Investor’s 2 share position ABCDX is now worth $160 ( $80 x 2 shares). His original $100 investment in ACBDX is now worth $160 (a 60% return).

Clearly, this turned out to be a good year for an investor, with his original $100 investment now worth $160 or a 60% return.

However, when the statement comes, the investor is puzzled, when he sees a -20% return under the “percentage return”. How is this possible? Here is how:

The shares of ABCDX declined $20 (or 20%) from January 1 to December 31. The difference between the investors return ( 60%) and investment return (-20%) is quite dramatic. So which matters more?

You can see that your return as an investor (or the dollar weighted return) shows you progress towards your goals and matters much more than the return of the investment itself ( time weighted return).

Yours is the return we seek to maximize by diversifying through time, reinvesting dividends and re-balancing your portfolio at regular intervals. We strive to steadily grow your portfolio, compounding its value, not chasing the latest hot performer.

And while there is almost certainly will be a better-performing investment somewhere out there (one with higher Time-Weighted return), you should resist the temptation of buying a “hot” stock or fund, abandoning your long-term strategy. Investors, who chase returns often, find themselves disappointed, when their account value does not reflect it. As very often the math is reversed, and a well-performing investment can produce a loss to an investor.

If you have any more questions about the IRR vs. TWR or your Quarterly Report, please contact us.

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