You measure your portfolio’s performance by its rate of return. What you probably don’t realize is there are actually different measurements. Understanding when to use which helps you make better financial decisions.
Two primary methods exist to assess your investment performance: time weighted rate of return (TWR) and internal rates of return (IRR). Although we try avoiding financial-speak whenever possible, the details of these two terms are worth understanding.
Just as you can measure someone’s height and weight, TWR and IRR measure two different dimensions of your portfolio’s returns, for very different reasons. Confuse one with the other, and you could end up believing that your portfolio needs to go on a high-fat diet so it can grow two inches taller.
In other words, even if a data point is correct, you can misapply its meaning. That’s why it’s worth knowing what TWR and IRR really mean, and when to use them for what.
TWR: your “apples-to-apples” return. TWR measures how your manager does. If you want to know if you and your advisor did a good job creating a portfolio mix that delivers acceptable returns, given the amount of risk you took, the time weighted rate of return is a good tool for that.
We’ll spare you the precise math involved, but TWR isolates the returns resulting from your portfolio’s make-up by eliminating other factors – especially cash moving in and out of your accounts. To further improve on the apples-to-apples comparison, we like to see TWR net of any advisor fees.
Consider, for example, 2005 to 2014 and the myriad events – Great Recession, subsequent bull market and recovery – during that time. TWR lets us measure the performance of your portfolio’s unique investment make-up and compare it with appropriate benchmarks during the same period.
IRR: your “where you stand” return. IRR measure the return in absolute dollars. It is useful for determining if your portfolio is growing fast enough to achieve your financial goals. For example, you’re investing for your kids’ college funding, and you want to know where you stand with gathering the raw dollars you need. For that purpose, your portfolio’s capital inflows, fees and other portfolio expenditures, and their impact on your returns become relevant.
Calculating the IRR involves using an initial return you guesstimate and adjusting it as often as necessary to arrive at the most accurate data point. Think of the process as an archer shooting at a target, adjusting his or her aim from the initial shots until hitting the bull’s eye. Needless to say, the calculations are best made with robust software dedicated to the role.
You don’t have to pursue a degree in mathematics to get a handle on your relevant returns, but we do believe knowing how to read these measurements is important, especially if you use them to make investment decisions.
If your investment performance reports don’t specify which return you’re viewing, it’s a question well worth asking. If they do specify, but you always wondered what they mean, now you know.
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Sheri Iannetta Cupo, CFP, is a principal of SageBroadview Financial Planning with offices in Morristown, N.J., and Farmington, Conn. The SageBroadview blog covers a wide range of financial planning and life topics.
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