Quick, do you know how much your investments earned last year? Are you certain? Well, if you relied on traditional methods to calculate your returns, you could be off, way off. The method most people use to calculate portfolio returns, regardless of the investment type, is by dividing the end value by the initial value; this method is also known as the Holding Period Return (HPR). If you deposited a lump sum, earned interest and/or dividends, and made no additional contributions or withdrawals, then using HPR is appropriate. However, if you are like most people, you make regular contributions to your savings, withdraw money for expenses, or both. In such cases, the HPR results in a less accurate evaluation of returns. The HPR is one of the simplest ways to measure performance, but is also the least accurate when there are cash flows such as additional contributions and withdrawals. When calculating performance, accuracy is critical because performance numbers are necessary to measure whether your investments have met your goals.
A more accurate way to measure performance when there are cash flows is by using the Time Weighted Return (TWR). Assume your portfolio was $100,000 on January 1st and $130,000 on January 31st of the same year and you made no additional deposits/withdrawals to your account; your holding period return would be 30 percent. However, now assume that you started the year with $100,000 in your portfolio, you made a $20,000 deposit on June 15, and the market value of your portfolio was $130,000 at the end of the year; do you know how much you made? As you can see from the table below, using the HPR, you would have calculated a 30 percent return on your portfolio. However, your actual TWR was only 7.39 percent, a significant difference.
|Date||Portfolio Market Value|
|June 15||$115,000||Includes $20,000 contribution|
|Holding Period Return (HPR)||30.00%|
|Time Weighted Return (TWR)||7.39%|
You’re probably wondering how TWR is calculated…
The TWR calculates a return for every period there is a cash flow, each period is called a sub-period, then the TWR links those sub-periods together through a process called chain-linking (similar to taking a weighted average). Using the example above, the return for the first sub-period (January – June 15) would be negative 5 percent; the return for the second sub-period (June 15 – December 31) would be 13.04 percent. The two sub-periods are chain-linked for a return of 7.39 percent. As you can see, the TWR is a more accurate method to measure performance because it is unaffected by cash flows. The biggest disadvantage of the TWR is that the portfolio must be valued anytime there is a cash flow; this is very difficult, if not impossible, for assets that do not have daily prices available such as real estate, private equity, and individual bonds. However, for investments held in accounts that are priced daily (i.e. IRAs, 401ks, savings accounts), it is best to use TWR in order to accurately measure performance.