When questioning your rate of return, the answer seems like a simple one to a simple question. However, like most financial matters, the answer is never as simple as it seems. There are actually various ways in which the rate of return of an investment is measured.
One such method is what is called the Time Weighted Return (TWR). This is a method most commonly used by mutual funds when quoting the performance of the fund. This method measures the performance of a specific investment over a specific period of time. This is used by investment companies because the manager of a mutual fund has no control over when investors will choose to withdraw or add money to their investment fund. Depending on when your personal transactions occurred, you may see a different return than what is quoted by the investment company.
Another method is the Internal Rate of Return (IRR). This method is designed to take into account the impact of cash flows either in or out of the investment fund(s). This is a better representation of your actual experience based on when you added or subtracted funds. This is also sometimes called a Money Weighted Return (MWR).
Which method should be used?
That depends on what you wish to measure. If your goal was to evaluate how well you or your advisor selected a set of investment vehicles relative to other options, you would likely use the TWR method. The reason is that short term market volatility may have a significant impact on short term results. If two separate investors allocated dollars in the precise same percentages to the same exact investments, but one began in January of 2020, and the other in April of 2020, the results are vastly different by August of 2020. Due to the fact that financial markets saw a steep selloff in the midst of the Coronavirus lockdowns, the outcome for the exact same strategy is wildly different in such a short duration of time. One investor may look foolish, while the other may appear to be a genius, yet they did the exact same thing just a few months apart. Neither is true, as the difference is little more than luck over such a short duration of time.
If you were trying to measure the performance of your 401k plan as you were saving for retirement via your bi-weekly contributions, you may have been recommended a growth-oriented asset allocation. It’s not uncommon for someone to be told that their asset allocation has had a rate of growth of 8%-9% over the last 10 years. However, when they look at their actual return, it may be closer to 7%. This is a function of the IRR/MWR.
If you think about this in simple terms, the stock market is up 75% of the time. This means that 3/4ths of the time you are paying more for the same investments every two weeks. If done over a forty-year career, you paid quite a bit more in year forty than in year number one. The same would be true even over a ten-year time frame. That means your personal return over all those years of saving will most certainly be lower than the actual return of those investments over that same time frame. This is not a reason to avoid investing, but it rather demonstrates the importance of starting early. The younger you are when you begin to save, the less total assets you need to save to achieve the same result.
In such an example, if you wanted to see how well you did in in your 401k terms of investment selection, you’d use the TWR. If you wanted to see your actual result in order to track your personal progress towards your retirement goals, you’d use the IRR/MWR. The same is true in the example of an investor withdrawing funds to supplement an income stream. The periodic cash flows withdrawn will inevitably alter their rate of return over time.
Neither of these methods is good or bad. Instead it’s just important to understand which question is being asked, which isn’t always clear, in order to answer the question with the best possible answer.