While investing doesn’t offer guarantees, you want to make sure the strategy you’ve built puts you on a path toward your goals. 

How can you do that? 

Determine your investment rate of return. Sure there are averages and estimations you can look at, but what do your numbers say? There are two ways to measure this performance stat: time and money-weighted calculations. 

Time is money, or is it?

What’s A Time-Weighted Rate of Return?

Before we dive into these two classifications, it’s important to remember that numbers are malleable, meaning that they can change based on the conditions surrounding them. You’ll notice that you can measure rates of return in different ways, but it is important that you understand your investment strategy and how it’s working for you.

Let’s start with time-weighted returns, or what you can think of as big picture returns. 

Time-weighted rates of return are a common indicator used to measure the performance of larger market indices like the S&P 500, mutual funds, or fund manager performance. It’s also a common way you’ll see your returns communicated, like in a brokerage account. 

With a time-weighted return, you look at the return of the initial investment over a select period. For example, investing $1,000 in the S&P 500 for a year. Your statement might indicate the change in the asset’s price or the price and the income and dividends. 

A time-weighted approach breaks the portfolio into time “snapshots” and evaluates its performance over that period to illustrate the broader trend.

While a time-weighted return looks at investment performances, this method doesn’t include cash flow factors like contributions, withdrawals, or any cash movement in and out of the portfolio. 

Why would this strategy discount this seemingly crucial element?

Cash flow is unpredictable, and the outcomes are dependent upon each individual investor. A fund manager, for example, can’t always control the cash flow of the fund, investors do, so their performance is measured without that uncontrollable factor.

Time-weighted returns are used to evaluate the performance of particular investments over time. 

What’s A Money-Weighted Rate of Return?

Money (or dollar) weighted rate of return often paints a much more vivid performance picture for individual investors because it does consider how cash flow, like contributions and withdrawals to the portfolio, impacts the performance. 

On top of that, it also considers the size and timing of the contributions. If you contributed a lump sum of $10,000 to your 401(k), your portfolio would feel the impact.

While the calculations get a bit in the weeds, the main thing you should know is that the portfolio’s performance is given more weight when there is more money in the account. 

Since cash flow is an essential element in money-weighted calculations, let’s break it down a bit further into inflows and outflows from your portfolio.

Cashflow into the portfolio

• Contributions
• Dividends or interest received
• Proceeds from the sale

Cashflow out of the portfolio

• Reinvested dividends or interest
• The price paid for an investment
• Withdrawals or cash removed. 

If there are no cash flows in or out of the portfolio, both a time-weighted and money-weighted calculation should have the same conclusion. 

Why Money-Weighted Works For Individual Investors

Both time and money-weighted rates of return offer investors a glimpse of how their investments are doing. While different, they both provide helpful information. 

However, if you’re looking for the most descriptive rate of return that accounts for your cash flow habits, stick with money-weighted. Since it includes your cash flows in and out of the portfolio, you see how your investment choices impact your portfolio performance. 

Accounting for investment behaviors is critical because so much about investing is understanding the non-financial elements that drive your portfolio: risk tolerance and capacity, time horizon, goals, and more. 

Time-weighted is a valuable metric, but it can be too high to portray the performance of many individual portfolios accurately. Just because it isn’t as effective on an individual basis, time-weighted returns are an excellent way to see the bigger picture of your investments.

There is no standard for calculating your investment returns. Each company and advisor will have its own process and system for tracking those numbers. It’s important to know how your advisor and investment accounts calculate this figure, as they may be different. For example, many 401(k)s use money-weighted returns, and many advisors use time-weighted returns. So you can’t really compare apples to oranges. 

Instead of comparing, be sure you understand precisely how your returns are calculated and what that means for your investments moving forward.

Find Confidence In Your Investment Strategy

You should understand how your investments work. 

Reading and fully comprehending your rates of return is a great place to start. Now that you have a better idea of how your portfolio’s performance is measured, you’ll find more confidence as you track your progress and invest in your future. 

Ready to read your returns like a pro? Get in touch with our team to review them today. We’d love to hear from you and help you find clarity and confidence in your investment plan. 

Disclosure:

Advisory services are offered through Legacy Wealth Advisors, LLC dba Legacy Wealth Advisors, an Investment Advisor in the State of Michigan. The information contained herein should in no way be construed or interpreted as a solicitation to sell or offer to sell advisory services to any residents of any State other than the State of Michigan or where otherwise legally permitted. All content is for information purposes only. It is not intended to provide any tax or legal advice or provide the basis for any financial decisions. Nor is it intended to be a projection of current or future performance or indication or future results. Moreover, this material has been derived from sources believed to be reliable but is not guaranteed as to accuracy and completeness and does not purport to be a complete analysis of the materials discussed. Legacy Wealth Advisors does not offer tax planning or legal services but may provide references to tax services or legal providers. Legacy Wealth Advisors may also work with your attorney or independent tax or legal counsel. Please consult a qualified professional for assistance with these matters.