Two Quantitative Methods for Measuring Return
Dollar-Weighted vs Time-Weighted
Imagine; you invest $100,000. Six months later you put another $100,000 into the same investment. Six months after that you sell all your shares for $300,000. After a few rounds of self- congratulation on your investment prowess you decide to calculate your return. You know you invested $200,000 and had gains of $100,000. Since your gain of
$100,000 is 50% of the $200,000 invested your gain is 50%. While this is a straightforward calculation something doesn’t feel quite right. Should the fact that only half the money was invested initially with the other half invested midway through the time period cause you to adjust your calculation? In search of answers you go online and find two rate of return calculators. You enter your data and click to the answer. One says you earned 66%, even better than your own calculation had indicated. But the other says your rate of return was… Zero-Yes, zero. Something must be wrong. You recheck your data and determine that both answers are correct. Welcome to the exciting world of dollar-weighted versus time-weighted returns!
In the example above, we see that it matters which method you use to calculate returns. There is a BIG DIFFERENCE between making 0% return and making 66%. Since, both are mathematically accurate, which one is right for you? In this issue of OUR PROCESS, I hope to help you understand a little better how these two quantitative return calculations are different and when one is more appropriate than the other.
First let’s get clear on how these two calculations differ. The time-weighted return formula diminishes the impact of cash inflows and outflows and is used to measure investment performance against itself or some baseline/benchmark. Dollar-weighted incorporates cash flows into the return calculation and gives you a better idea of the returns earned on the money that you had at risk.
A money manager typically is working with OPM- other people’s money. They are entirely removed from any knowledge of their investors and do not have any interest in getting involved with shareholder cash flow needs So, it is understandable that a money manager would want to see returns based on how he/she is doing against a certain benchmark. Because a manager cannot control when you want to buy a new car or take a nice vacation, he does not want to have “his/her” returns reflect cash flows. This is why in the financial services industry – an industry filled with product salesman, the standard quantitative method for calculating return is the Time-weighted return method. To put it bluntly, time-weighted returns tell a money manager how he/she is doing. It really has nothing to do with you at all as evidenced repeatedly in the measured disparity between investment return and investor return.
Conversely, if it’s your money and you want to know how you’re doing, your first choice will be to measure everything in dollar-weighted returns. In the real world, everyone experiences cash flows - EVERYONE. And since cash flows affect return performance, it should be factored into the performance equation. If you truly want to know how your own portfolio is doing, you need to measure returns using the dollar-weighted method.
The financial engine that drives the confidence ratings in our Goals-Based Wealth Management Process not only utilizes dollar-weighted returns for each client, but also factors in all portfolio costs for a truly honest appraisal of performance. This is just one of the numerous efforts we take to make your relationship with VanDerNoord Financial Advisors, Inc. more meaningful.