Rate of Return: Simple, Internal and Time Weighted

Rate of Return: Simple, Internal and Time Weighted

As financial advisors that provide investment monitoring and a broad range of investment products, we are often asked this question: “What is my rate of return?” As it turns out, this question has not one but several answers. There exist several different measures of return that financial planners and financial advisors use to help their clients make better, more informed financial decisions. Here’s what you need to know.

What is the Simple Rate of Return (SRR)?

The SRR, as the name suggests, is the easiest return measurement to understand. The SRR measures the percentage change in market value. It does not take into account cash flows that affect the underlying performance of an investment. Therefore, the SRR is not a good tool for measuring the return of your investment portfolio.

What is the Internal Rate of Return (IRR)?

The IRR does give a good measurement of the growth of an investment portfolio. Sometimes called a dollar weighted return, the IRR is the measurement of an investment portfolio’s performance between two dates including the effects from cash flow. Because it gives greater weight to periods when more money is invested in the portfolio, the IRR is affected by the size and timing of cash withdrawals and contributions. The IRR is an excellent tool to help financial planners and retirement planners understand if an investment portfolio is growing enough to meet a specific investment goal.

The IRR is affected by so many factors, however, that it is not is a tool for analyzing the underlying assets of a portfolio, for long-term investment monitoring, or for gauging the success of your investment manager. For that, the Time Weighted Return TWR is a better tool.

What is the Time Weighted Return (TWR)?

The TWR eliminates all the effects of additions and withdrawals that occur over a given time period and instead demonstrate the return on the first dollar invested in the portfolio. Because it removes much of the background noise and disruptions caused by cash inflows and outflows, the TWR is a great tool for comparing your investment manager’s performance against other investments. On a technical level, the TWR is determined like this:

– Divide up the performance period into shorter sub-intervals, like one month or three months.

– Then, these sub-intervals can be divided into smaller intervals based on the date of any additions or withdrawals.

– Finally, the Internal Rate of Return (IRR) is calculated for each sub-interval and the individual IRRs are linked together with equal weighting to find the portfolio’s Time Weighted Return.

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