Special to the Recorder
Assume the hypothetical scenario:
• An investor invests $100,000 on Jan. 1, 2012.
• At the end of year 1, the investment returned 20 percent, or $20,000.
• The investor decides to invest another $1 million on Jan. 1 of year 2.
• At the end of year 2, the investment returned 5 percent, or $56,000 ($1.12 million X 5 percent).
• The investor made a total profit of $76,000.
• The stock market return for the period was 10 percent.
Question: What is the investor’s rate of return?
Answer: The dollar-weighted return is 6.3 percent and the time-weighted return is 12.25 percent.
Whoa! Are you confused? If YES is your answer, join the crowd, as many investors have a somewhat difficult time grasping this concept. Please allow me to explain this very important difference between the returns.
The dollar-weighted and time-weighted methods compute a compound return of one’s investment portfolio. The dollar-weighted method can distort a person’s investment management abilities because the timing of when the dollars are added to and subtracted from a portfolio weighs heavily on the ultimate compound return realized. The time-weighted method concerns itself only with how well the investment manager manages one dollar over the entire time horizon.
Please stay with me on this. It gets easier. With the above example, the portfolio manager did quite well with a compound annual return of 12.25 percent over the two-year period, especially considering the stock market return was 10 percent during the same period. It was not the manager’s decision to add the largest amount of dollars at the beginning of the second year. Because of the client’s timing decision, more dollars were put at risk during a period when the return was lower. Had the investor invested the $1 million in year 1, the dollar-weighted return would have been much closer to the time weighted return.
Bottom line: Which return should you use? If you want to compare your portfolio manager’s performance to other managers or the stock market, you should use the time-weighted return. If all you want to know is the compound percentage growth of your money, use the dollar-weighted return. As you can see from the above, an investor can be disappointed with their return if they look at dollar weight. If they use the time-weighted method, however, they see the manager outperformed the market
That’s it. I promise. No more technical stuff. Allow me to conclude by saying the above example and commentary are one reason that portfolio managers (mutual funds, etc.) are evaluated using the time-weighted rate of return instead of the dollar-weighted rate. Please keep in mind that the end result does not always work in the favor of the portfolio manager.
Source: The following material has been excerpted from the College for Financial Planning’s Investment Planning course.
Harry Pappas Jr. CFP®
Managing Director-Investments
Master of Science Degree Personal Financial Planning
Certified Estate & Trust Specialist ™
Certified Divorce Financial Analyst™
Pappas Wealth Management Group of Wells Fargo Advisors
818 North Highway A1A, Ste 200
Ponte Vedra, Florida 32082
904-273-7955
harry.pappas@wellsfargoadvisors.com
The use of the CDFA™ designation does not permit Wells Fargo Advisors or its Financial Advisors to provide legal advice, nor is it meant to imply that the firm or its associates are acting as experts in this field.
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