Understand different approaches to correctly measure your investment performance

David Peartree, BridgeTower Media Newswires

The absence of a uniform standard for reporting investment performance presents a challenge for investors. As a rule, investment advisers are not required to report investment performance and, even if they do, there is no uniform standard for how the performance should be reported.

In a recent article ("Correctly measuring your investment performance") we discussed some of the challenges and misconceptions about correctly measuring investment performance. Here we take a closer look at several of the most commonly used measures for reporting investment returns. Different approaches can sometimes yield very different results, so it pays to know what the numbers mean.

The most basic approach to measuring investment returns is simply to determine the change in value over time. We will call this the Simple Rate of Return. The Simple Rate of Return determines the gain or loss in market value relative to the beginning value of an investment. Under this approach, an investment of $125,000 that increases in value to $143,750 has gained 15% ($143,750 / $125,000 = 1.15 or 15%). The Simple Rate of Return is easy to calculate and, therefore, tempting to use, but it is not necessarily an accurate measure of investment performance.

What if the 15% return in the above example occurred over a period of five years and we want to know the average rate of return? The simple arithmetic average is 3% (15 divided by 5). The math is correct but the answer is wrong. The average annual rate of return once we account for the impact of compounding is only 2.83%. The arithmetic average overstates the actual returns.

If returns vary greatly from one time period to the next then a simple arithmetic average becomes even less accurate. This is especially true if returns range from positive to negative values as market returns often do. We need to use a type of average known as the "geometric" average to deal with the reality of market returns that vary from one time period to the next.

Another complication is the impact of cash flows in or out of an investment. Investors will often make contributions to or withdrawals from an account at different times and in varying amounts. Contributions should not be counted as investment gains and withdrawals should not be counted as investment losses.

These complications - multiple time periods, widely varying returns from one period to the next, and varying cash flows in or out of an investment - need to be addressed. There are two basic approaches to choose from: the dollar-weighted return, also known as the "internal rate of return" or IRR, or the time-weighted return.

The names are not very intuitive, but an example will illustrate how these two approaches differ in what they measure. Let's assume an investor invests $10,000 in a fund, earns 10%, and by the end of the first year has an investment of $11,000. The investor then adds another $10,000 but proceeds to lose 8% over the second year, ending with a value of $19,320, less than the total investment. What is this investor's return?

Since this investor lost money, we would expect a negative return but the investor's time-weighted return is a positive 1.2%. The time-weighted return measures the return from the first dollar invested and ignores subsequent cash flows. The investor's dollar-weighted return, however, is a negative 2.3%, more in line with our intuitive expectations.

In the dollar-weighted return calculation the 8% loss is given greater weight than the 10% gain because it applies to a larger sum. The 10% gain only applied to the initial investment of $10,000. The 8% loss, however, applied to the initial investment, the gain on that investment, and the second investment of $10,000. If there are no cash flows in or out, the dollar-weighted return and the time-weighted return should be the same, but if contributions or withdrawals are taking place the two returns can be quite different.

It's not a matter of one approach being right and the other wrong. The two approaches serve different purposes. The dollar-weighted return is better suited to measure how the investor has fared, while the time-weighted tells us how the fund manager has performed. After all, the fund manager doesn't control the timing or amount of the investor's contributions or withdrawals and should not be assigned blame, or given credit, where none is due.

There is no requirement that investors working with a professional adviser be informed of their rate of return. To the extent that there is a widely used reporting standard, it is probably the time-weighted return. The time-weighted return conforms to the Global Investment Performance Standards (GIPS) created by the Chartered Financial Analyst Institute. It is a valid measure for money managers or fund managers who do not control the funds flowing in or out of their management.

Most individual investors, however, are more interested in how they have fared, and for this purpose they will want to know their internal rate of return, that is, their dollar-weighted return. If it's not being provided, ask for it. Without that information, it's difficult for investors to assess how they have performed relative to their financial goals and expectations.


David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625, david@worthconsidering.com.

Published: Mon, Apr 24, 2017