As a society, we are conditioned to keep score. We like numbers – bigger is usually better - sans waistlines and mortgages. They make comparisons simple – be it our car’s gas mileage, grocery shopping, Michelle’s unassisted pullups[i], and, certainly, investment performance. In this month’s edition, we’ll compare the two main return calculations: Time Weighted and Internal Weighted Return. So as not to punish our readers, I’ve omitted the mathematical formulas but will still discuss how to accurately relate performance measurement to your individual portfolios. Lastly, we’ll pinpoint some common investor performance pitfalls & how to avoid.
Performance Calculations
Time Weighted Return (TWR) – Using this measure, cash outflows and amounts invested over different time periods have no effect upon stated return. This method stabilizes the effects of deposits/withdrawals over time. This method is officially endorsed by the Association of Investment Management & Research (AIMR). This is also the method Houlihan uses on year-end performance reports.
Internal Weighted Return (IRR) – This method is also referred to as dollar-weighted return. The IRR differs from TWR in that it calculates the return rate at which the present value of cash outflows equals the present value of inflows. In effect, deposits/withdrawals and amounts invested over time do have a material effect on return.
For most investors, TWR gives the more representative return picture. But for those active investors who engage in market timing & measure very short time intervals, IRR is likely the proper calculation. Mutual fund companies usually report using TWR. But that is why your personal performance can vary greatly from a mutual fund’s stated performance depending on your investment timing (IRR). For passive investors, the numbers usually wash out evenly.
Measuring Performance: Real vs. Nominal Returns
Nominal Return – The nominal return (also referred to as Simple Return) is the return you see posted by a bank listing CD rates. For instance, you might see an advertisement of 2% for 12 months. Simply put, you can expect to earn $2 for every $100 invested in one year’s time.
Real Return – The real return takes into consideration inflation. This is rarely advertised. So, assuming you earned 2% on your CD, but inflation is 3%, your real return was -1%. Think of real return accounting for your cost of living and purchasing power. It portrays a more accurate economic return on assets. Think back to the early 1980’s when CD’s were paying 18%+. What’s conveniently forgotten was 16% inflation (and marginal tax rates as high as 70%). While the nominal rate (18%) was very appealing; the real rate (2%) was similar to today’s rates. The good ‘ol days weren’t that great.
Relating Performance: Absolute vs. Relative Returns
Absolute Return – The absolute return is simply whatever the portfolio earned. It doesn’t consider what different markets or asset classes did. Some investors simply want a definite return, regardless of interest/inflation rates and economic conditions. The hidden risk is that the return will not maintain pace with inflation.
Relative Return – The relative return measures the portfolio return vs. an index. For example, the S&P 500 is a common benchmark investors might measure their individual performance against. Just make sure an accurate benchmark is chosen. It would be senseless to compare a portfolio of cash & CD’s to an equity index or a domestic portfolio to an international standard. Think apples to apples.
The issue we run into as investment managers is the tendency of investors to vacillate their return goals between absolute & relative. For example: during bear markets, we all want some kind of positive, absolute return while broad markets are tanking. But as soon, as the markets recover, we want all that upside & relative return. This moving of the goal posts is unrealistic & ruinous to investment policies.
Rule of 72
This is simply a back of an envelope method to figure out how long it takes for money to double at a given rate of return. Nothing magical but an easy heuristic that can roughly help you project the compounding time value of money. I hesitate sharing this as clients think I’m Rain Man in meetings. See the figure below.
