Weekend Reading: Gain, Loss & Performance, Episode 2

Dear Clients and Friends,

A few weeks ago, we wrote an article discussing the differences between “Principal Gain & Loss” versus “Tax Gain and Loss.” This article was inspired by questions we’ve received about why growth in a particular investment held by many of our clients appeared to have achieved better performance than its tax liability was suggesting.  This question inspired us to discuss more broadly several types of performance measures and the differences between them.  This week, we are going to write about two more performance figures, specifically “Time-Weighted Return” (TWR), and “Internal Rate of Return” (IRR). The differences between these two are very important and we use both during every client review. So pay attention, this is good stuff!  

Let me start by giving you an example of why we need to use both.

Let’s say you deposit $1 million into an account on January 1st, and another $1 million into the same account on December 30th.  On December 31st, your account is worth $2,100,000.  In this example, you’ve deposited a total of $2 million, and you’ve earned $100,000, which represents a 5% return. But does it really? 

The second deposit was only in the account for one day.  Therefore, you probably earned the $100,000 on only the first million deposited. Which means the $100,000 profit you made on $1 million equals a 10% return, not a 5% return. 

On the other hand, what if you put both deposits into one single technology stock that remained stagnant all year. Then, on the morning of December 31st, that stock reported great earnings and it shot up 10% on that single day.  In that case, you really did earn $100,000 on the full $2 million which means you earned 5%, not 10%.  So, which is it???

This example illustrates that the timing of your deposits (or withdrawals) can have a serious impact on your calculated performance.  Since most people deposit/withdraw money throughout the year, and investments fluctuate every day, we cannot simply say you earned “x” amount of dollars this year on a portfolio worth “y” amount of dollars.  We need a better way.

We need a calculation metric that removes the timing of your deposits from the equation, almost as if we calculated your performance every single day of the year independently, and then merged all 252 trading days together.  In fact, that is sort of what we do, and it’s called “Time-Weighted Return.” Investopedia describes Time-Weighted Return as a measure of performance which “Eliminates the distorting effects on growth rates created by inflows and outflows of money.”  This makes TWR a useful barometer when comparing your portfolio return to a published benchmark appropriate for your risk tolerance, and is therefore one of the performance measures we use at every client review meeting.

Albeit very useful, there is a flaw with TWR in that sometimes we want to include the timing of cash flows.  For example, if we are evaluating the performance of a single investment within your portfolio, we may be more interested in how much money this investment has made for us, including dividends and interest, regardless of timing.  And for better or worse, the timing of such dividend and interest payments does matter, especially if they are reinvested.  At the end of the day, we may not care about whether the timing helped or hurt us, we just want to know whether or not we made the amount of dollars we were hoping for. 

If we want to earn $100,000 (as in our first example) we may or may not care whether we made the $100k on $1 million or $2 million, we just want our $100 grand. This target is a dollar figure, and thus, we refer to this as “Dollar-Weighted Return,” or more commonly “Internal Rate of Return” (IRR).  IRR is a measurement of a portfolio’s actual performance between two dates, including the effects from all cash inflows and outflows.  Because cash flows are factored into the calculation, greater weighting is given to those time periods when more money is invested in the portfolio. Therefore, the IRR of a portfolio or an investment can be significantly affected by both the size and timing of any cash contributions or withdrawals.

Insomuch as your financial plan is based on how much money, or how many dollars, your portfolio is earning, we use IRR to determine whether or not your portfolio is keeping pace with your long term financial goals.  But because everyone has different timing with regard to their deposits and withdrawals, IRR is not useful for comparing two different portfolios.  Since TWR eliminates the impact of withdrawals and deposits, TWR is much more useful when comparing your portfolio performance to that of other investors, or to a publicized risk-based benchmark. 

More simply put, IRR helps us compare your portfolio to your goals, while TWR helps us compare your portfolio to your peers. IRR helps us determine whether or not we, as financial planners, are helping you accomplish your financial goals, such as accumulating enough money for retirement; TWR helps us, as investment advisors, to determine whether or not your portfolio is kicking butt, or sucking wind.

By the way, for those interested, in the first example we discussed (investing $1 million on January 1st, investing another million on December 30th, and showing a portfolio value of $2,100,000 on December 31st) The Time-Weight-Return = 5.01% whereas the Dollar-Weighted or Internal Rate of Return = 9.948%.  Pretty crazy, isn’t it?!

So… what a mouthful! Over these 2 episodes of our weekend reading, we’ve discussed four different performance measures, all relevant in different ways.  One for absolute performance (Principal Gain and Loss), one for relative performance versus your financial plan (IRR), another for relative performance versus your peers (TWR), and a fourth for tax purposes (Tax Gain & Loss).  And to poke fun at ourselves, we scrutinize each of them every day!

That’s all for today. I hope we’ve kept your attention and we wish you a wonderful weekend.

-MR


Matthew Ramer, AIF®
Principal, Financial Advisor
MOR Wealth Management, LLC

1801 Market Street, Suite 2435
Philadelphia, PA 19103
P: 267.930-8301 | c: 215-694-4784 | f: 267.284.4847 |

601 21st Street, Suite 300
Vero Beach, FL 32960
P: 772-453-2810

matthew.ramer@morwm.com | www.morwm.com

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