Understanding the Different Types of Investment Returns
When your financial advisor reports the return you received on your portfolio, it is crucial to understand exactly which return you are looking at. The two types are time-weighted return and the internal rate of return (also known as dollar-weighted).
The time-weighted return can be described as the return received on the first dollar invested. It is obtained by adjusting consecutive period ending values to remove the impact of cash flows. Here is an example: Suppose I start with $1,000 on 1/1/2017 that grows to $1,200 on 6/30/2017 at which point I add $800, and by 12/31/2017, I have $2,100. This is equivalent to saying I had a 20% return for the first half of the year followed by a 5% return for the second half. Combining these two returns results in a 2017 return of 26%. Note that the half-year returns are not simply additive due to the compounding effect.
The internal rate of return (IRR) can be described as the return received on all dollars invested. It is impacted by intermediate cash flows, either positively or negatively. Returning to the example above, the IRR is 21.7% or the interest rate that equates the accumulated value of the two deposits with the ending account value. In this case, the IRR is less than the time-weighted return because the hypothetical investor added funds after a great half-year return only to receive a much lesser return in the second half.
The time-weighted return is the appropriate choice for comparing to a benchmark return such as the S&P 500 Index, while the internal rate of return is used to determine if the investor is achieving his required rate of return to meet his goals. Through our client portal, we give our clients access to both returns as of any date desired. Does your advisor do that? If not, maybe it’s time for an upgrade. Call us at 800-345-4635 or email us at firstname.lastname@example.org.