Understanding Performance Metrics for Informed Investment Decisions

Last week's article on Average Returns vs. Actual Returns - Understanding The Difference received quite a bit of praise, so let's continue the conversation to discuss two different common rate of return metrics used when discussing investment portfolios.

Two commonly used metrics are the time-weighted rate of return (TWRR) and the money-weighted rate of return (MWRR).

These metrics provide insights into how an investment has performed over a specific period. Understanding the differences between TWRR and MWRR and knowing when to use each can empower investors to make informed decisions about their future investment strategies.

Let's get into the calculations and considerations associated with TWRR and MWRR to help you better understand these performance measures.

## Time-Weighted Rate of Return (TWRR):

The time-weighted rate of return is a metric that focuses on the overall performance of an investment portfolio, regardless of any additional contributions or withdrawals made by the investor during the evaluation period.

It eliminates the impact of investor activity (money added or withdrawn) and provides a measure of the manager's investment decisions.

To calculate TWRR, follow these steps:

1. Divide the evaluation period into smaller sub-periods based on when contributions or withdrawals occur.

2. Calculate the sub-period returns by dividing the ending value by the beginning value, subtracting 1, and converting it into a percentage.

3. Calculate the geometric average of the sub-period returns by multiplying the (1 + return) values for each sub-period and raising it to the power of (1/n), where n is the number of sub-periods.

4. Subtract 1 from the result in step 3 and multiply by 100 to get the TWRR.

Example: Suppose an investment portfolio has the following sub-period returns: 5%, -2%, 3%, and 7%. The TWRR would be calculated as follows:

(1 + 0.05) x (1 - 0.02) x (1 + 0.03) x (1 + 0.07) = 1.1291

TWRR = (1.1291 - 1) x 100 = 12.91%

## Money-Weighted Rate of Return (MWRR):

The money-weighted rate of return, also known as the internal rate of return (IRR), takes into account the timing and magnitude of investor contributions or withdrawals.

It reflects the overall return an investor has earned on their investment based on the specific cash flows and their respective timing.

Calculating a MWRR involves finding the rate of return that makes the net present value of all cash flows equal to zero, you can utilize financial software or investment tracking tools (excel has a nifty XIRR function) to help you calculate that.

Example: Let's consider an investor who contributes \$10,000 at the beginning of the year and an additional \$5,000 six months later. At the end of the year, the investment is worth \$18,000. The MWRR would be calculated as follows:

MWRR = IRR(\$10,000, \$5,000, -\$18,000) = 40.4%

## Which Metric Should You Consider When Evaluating Your Portfolio?

Both TWRR and MWRR serve specific purposes and offer different perspectives on investment performance. The choice of which metric to use depends on the investor's goals and the specific context in which the performance is being evaluated.

• TWRR is particularly useful when comparing the performance of multiple investment managers or evaluating the success of an investment strategy over time. It removes the impact of investor contributions and withdrawals, providing a clearer picture of the investment manager's skill.

• MWRR, on the other hand, is valuable when tracking personal performance or assessing the impact of timing and magnitude of cash flows. It reflects the returns experienced by the investor, considering their specific actions.

Understanding the differences between TWRR and MWRR empowers investors to make more informed decisions when evaluating the performance of their investment portfolios. While TWRR provides insights into the investment manager's decisions over time, MWRR takes into account the impact of an investor's actions on the overall return.

By recognizing the strengths and limitations of each metric, investors can effectively track account performance and make more informed decisions about future investment strategies.

Please note that consulting with a financial advisor is recommended to ensure the appropriate performance measurement is used based on your individual circumstances and investment goals.

Remember, staying well-informed about investment performance metrics is a crucial step toward a successful retirement.