There are three basic methods to measure the returns of your portfolio:
- Time Weighted Return (TWR)
- Money Weighted Return (MWR) (also known as “Dollar Weighted Return” or “Internal Rate of Return”)
- Holding Period Return (HPR)
Time weighted return is probably the one you’re most familiar with. You look at your quarterly statement, you see some return number, you are happy if it’s a big positive number or you are sad if it’s a negative number. You’re looking at the time weighted return. TWR is handy as it ignores funds deposited and withdrawn from a portfolio, so it is typically the best measurement of the performance of the underlying assets comprising the portfolio itself. Imagine getting paid a bonus at the market bottom in March of 2020 and stuffing it all into your equity portfolio – the results look great by the end of the year but not necessarily because your portfolio outperformed. It was because you luckily added money at the right time. TWR removes distortions created by cash inflows and outflows.
Money weighted return considers what time weighted returns purposefully exclude: cash inflows and outflows. If you are someone – or you have hired someone – to try to time the market (get in when it’s down, get out when it’s up, etc.),* money weighted returns are the best measure of performance. If you intentionally waited until the bottom in March of 2020 to invest, the MWR will reflect your prudent timing.**
Holding period return is a simple measurement you will never find on a statement but most accurately reflects the real-life growth of your portfolio. It is the rate of change calculation you learned in sixth grade. You remember those math problems… You own an apple orchard. Last year your orchard produced 100 apples. This year it produced 110 apples. By what percent did your apple yield increase from year one to two? You learned to divide the difference (110 - 100 = 10) by the original number (100) for the rate of change: 10%. Apply the same elementary calculation to your portfolio and it’s called the holding period return. You start the year with $100,000 and end the year with $110,000, that’s a 10% HPR.
MWR and HPR differ in that the MWR takes into account the present value of cash flows – it is a bit more complex a computation. We’ll focus on TWR and HPR. They can be distilled:
- Time weighted return: what your statement says
- Holding period return: how much your portfolio actually grew (or shrank)
Many people (pre-retirement) add funds to their portfolios on a semi-monthly or monthly basis: (401(k) deferrals, Roth IRA contributions, etc.) There is a term for this – “dollar cost averaging.” We are raving fans of this discipline. Dollar cost averaging has two magical*** qualities:
- Behaviorally, it makes directing some of your income to investing rather than consumption much easier. You setup 401(k) deferrals, the money goes directly to your 401(k), you never see it. Or you setup a $500/month contribution to your Roth IRA on the 1st of each month from your checking account. Three months later, you forget it’s happening. But you’re investing money every month. Magic.
- Mathematically, it can cause your holding period return (your portfolio in real life) to exceed your time weighted return (the return of the underlying assets you own). So you effectively outperform your own investments. Magic.
Imagine adding $500/month to your investment account from 11/8/21 – 11/8/23 and investing 100% of those funds into an S&P 500 ETF (ticker: SPY). During that period, the S&P 500 ETF itself returned -3.84%. That’s the time weighted return:[i]
Here’s your portfolio after adding $500/month during that period:[ii]
The return of the asset you invested in was negative (-3.84%), but your portfolio balance is greater than the sum of your contributions. Magic.
You invested $12,000 over a two-year period ($500/month x 24 months) and your portfolio balance is $12,730.76. That’s a holding period return of +6.09%. All while the time weighted return was -3.84%. A swing of +9.93% simply by swapping the method by which you calculate your portfolio return. So:
Your statement says you lost money (TWR).
Your account balance says you made money (HPR).
Which is more important to you?
Rory and I along with the rest of our investment committee manage portfolios of other people’s money, so we focus on time weighted returns. But when I’m looking at my own portfolio… well, I can’t eat time weighted returns. I like seeing that account balance go up.
A simple rule of thumb: consistently contributing to your investment account during choppy markets will likely cause your holding period return to exceed your time weighted return, possibly by a wide margin.
Dollar cost averaging in choppy markets is like magic. You can outperform your own investments.
2022 is fresh on everyone’s mind. Not a fun year in the markets – here’s the same S&P 500 ETF for the ’22 calendar year:[iii]
Down 18.17% - that’s the time weighted return. The return quoted on your statement. Not fun. What if you invested $500/month into the same S&P 500 ETF each month of 2022? Here’s the results:[iv]
$6,000 of total contributions ($500/month x 12 months) during the year yielded an account balance of $5,628.56. That’s a holding period return of -6.19%. Still a negative number, but a swing of +11.98% compared to the -18.17% TWR.
Your statement says you lost 18%. Ouch.
Your account balance says you only lost 6%. Ouch, but not nearly as bad?
A simple rule of thumb: consistently contributing to your investment account during a down market will cause your holding period return to exceed your time weighted return, possibly by a wide margin.
Dollar cost averaging in a down market is like magic. You outperform your own investments.
Sean Cawley, CFP®
*This cannot be done consistently with any statistical measure of accuracy. Run far far away from anyone telling you they’re able to do what no one else can.
**Again, don’t try this at home and certainly don’t hire anyone who says they can do it for you!
***Not actually magic! Just math. But the math seems kinda magical, doesn’t it?
Neither asset allocation nor diversification guarantee against investment loss. All investments and investment strategies involve risk, including loss of principal.
Content here is for illustrative and educational purposes only. It is not legal, tax, or individualized financial advice; nor is it a recommendation to buy, sell, or hold any specific security, or engage in any specific trading strategy. Results will vary. Past performance is no indication of future results or success. Market conditions change continuously.
This commentary reflects the personal opinions, viewpoints, and analyses of Resolute Wealth Management. It does not necessarily represent those of RFG Advisory, clients, or employees. This commentary should be regarded as a description of advisory services provided by Resolute Wealth Management or RFG Advisory, or performance returns of any client. The views reflected in the commentary are subject to change at any time
[i] YCharts, Fundamental Charts, SPY Total Return Level, 11/08/21 – 11/08/23.
[ii] YCharts, Scenario Builder, SPY, $500/month contributions 11/08/21 – 11/08/23.
[iii] YCharts, Fundamental Charts, SPY Total Return Level, 01/01/2022 – 12/31/2022.
[iv] YCharts, Scenario Builder, SPY, $500/month contributions 01/01/2022 – 12/31/2022.