Introduction
Investors are always looking for ways to maximize their returns, and two popular methods for measuring investment performance are time-weighted return (TWR) and money-weighted return (MWR). While both methods have their advantages and disadvantages, understanding the differences between the two can help investors make informed decisions about their investment strategy.
What is Time-Weighted Return?
Time-weighted return is a method used to calculate the performance of an investment portfolio over a specific period of time. It measures the compound rate of growth of the portfolio assuming that all cash flows (deposits and withdrawals) occur at the beginning of the period. This method is useful for comparing the performance of different investments over the same period of time.
Example:
Suppose an investor puts $10,000 into an investment at the beginning of the year, and the investment grows to $12,000 by the end of the year. However, during the year, the investor withdraws $1,000. The time-weighted return for the year would be 20%, calculated as follows: [(Ending value of portfolio / Beginning value of portfolio) ^ (1 / Number of years)] – 1 [(12,000 / 10,000) ^ (1/1)] – 1 = 0.20 or 20%
What is Money-Weighted Return?
Money-weighted return, also known as internal rate of return (IRR), is a method used to calculate the performance of an investment portfolio that takes into account the timing and size of cash flows. This method is useful for measuring the actual rate of return earned by an investor on their investment.
Example:
Suppose an investor puts $10,000 into an investment at the beginning of the year, and the investment grows to $12,000 by the end of the year. However, during the year, the investor withdraws $1,000. The money-weighted return for the year would be 8.7%, calculated as follows: IRR = -10,000 + (1,000 / (1 + r)) + 12,000 = 0 Solving for r, the money-weighted return for the year is 8.7%.
Which Method is Better?
Both time-weighted return and money-weighted return have their advantages and disadvantages, and the method that is better depends on the investor’s goals and the specific circumstances of their investment. Time-weighted return is useful for comparing the performance of different investments over the same period of time, and it is not affected by the size or timing of cash flows. However, it does not reflect the actual rate of return earned by the investor. Money-weighted return takes into account the size and timing of cash flows, and it reflects the actual rate of return earned by the investor. However, it can be affected by the timing and size of cash flows, and it may not be comparable to the returns of other investments.
Conclusion
In summary, understanding the differences between time-weighted return and money-weighted return is important for investors who want to make informed decisions about their investment strategy. Both methods have their advantages and disadvantages, and the method that is better depends on the investor’s goals and the specific circumstances of their investment. By understanding these differences, investors can choose the method that best suits their needs and helps them maximize their returns.
