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Understanding Investment Performance Returns

Paul Bryer

So, what's the big deal? We get a quarterly or annual statement with our rate of return on it. It seems ok - or maybe not ok - based on what I know about how I'm invested. If it's up I'm happy. If it's down, I'm unhappy. If that sounds familiar, I'm going to let you in on something. The big secret is that those return calculations we see can be calculated in several different ways and they are definitely NOT the same. Oh yes, and they can be totally misleading. So then maybe they are not super-helpful for making decisions about our financial future. So, then which return metric is the best to use and why? Here are a few you have probably seen on your statement or in an investment prospectus:

  • Average rate of return

  • Holding period return

  • Dollar-weighted rate of return

  • Time-weighted rate of return


I am going to go over each one of these and hopefully discover what may be best to use.


Number one on deck is Average Rate of Return. Perhaps one of the most misleading of all statistical measures. It masks the true performance of a portfolio and is very easy to manipulate. Here is a demonstration to prove this out. Pretend we have an investor. In January of year one, this investor puts $100,000 into their account. At the end of the year, the portfolio returned 50%, or $50,000. So now this investor's balance is $150,000. Easy enough. In year two, the portfolio loses -50%, or $75,000. The balance at the end of the year is now $75,000. What is this portfolio's average rate of return? Yes, that's right - 0%. Why? The average of year 1 (+50%) and year 2 (-50%) is zero. Obviously the balance is not zero and is actually lower than where they started at $100,000. So is the rate of return actually zero? You get the picture. Measuring portfolio return in this way is highly dependent on the time period you are using in the average - for instance, using the two years as shown in the example above, or instead we use 10 years of returns. It also completely masks portfolio volatility. Average return numbers might seem on the surface to be "good" (or bad) and will provide false confirmation of a portfolio's true performance. And averages can be easily manipulated to show positive or negative results.


Number two is Holding Period Return (HPR). This is the most often self-calculated rate of return number. It easy to do - you take the ending balance, subtract the beginning balance, add any dividends, and divide this by the beginning balance. From the above example, Year 1's HPR would be $150,000 - $100,000 + $0 / $100,000 = 50%. This calculation is very useful for shorter time periods. The caution in using this return calculation is that it does not account for reinvested dividends, does not account for cash flows in the portfolio (contributions/withdrawals), and longer time periods will really skew the results. So we can use this one sparingly and for quick metrics during the year. It helps answer the question, "Is the performance on track?".


Number three is Dollar-Weighted Rate of Return (DWRR). Also called the Money-Weighted Rate of Return or the Internal Rate of Return (IRR), this calculation does take cash flows into account that happen during the year (contributions and withdrawals). But since your cash flows are unique to your portfolio, this means that DWRR should only be used to analyze your portfolio by itself, and not compared against any other portfolio or benchmark like the S&P500 index. It gives us a picture of how changes in the portfolio affect the performance (the cash flows skew the return calculation). The question we would ask when using DWRR as our return metric is "Is my portfolio generating a consistent return over time? Am I getting what I expected given the risk I'm taking?"


Lastly, number four is Time-Weighted Rate of Return (TWRR). Also called the Geometric Rate of Return, this calculation ignores cash flows completely, as what we just talked about, they definitely skew the return results. It calculates the compound growth rate of the portfolio. This return is the most useful to use to compare with other portfolios and benchmarks. Portfolio managers use this metric to compare portfolios and help select optimal investment portfolios. This metric answers the question, "How does my portfolio's performance compare to its associated performance benchmark over time?". Most of the time this is presented as a back-tested graph of returns. But that is a topic for another day.


So, there you have it. Next time you get your portfolio statement, take a closer look at it and what the performance calculation looks like. Sometimes the method they used is in the fine print at the back of the statement. Check it out! If you need further help deciphering your portfolio's performance, or are unsure what the performance should be, reach out to us anytime. We are here to help. Blessings and keep investing for the Kingdom!

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- Paul Bryer at Inspire Advisors

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Advisory Services are offered through Inspire Advisors, LLC, a Registered Investment Adviser with the SEC.

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