Investment performance measurement uses two primary methods: Money-weighted return and Time-weighted return. Money-weighted return considers the timing and size of cash flows into and out of the portfolio, making it sensitive to when investments are made. Time-weighted return, on the other hand, eliminates the impact of cash flow timing to focus purely on portfolio performance.
Money-weighted return, also known as the Internal Rate of Return, calculates the discount rate that makes the net present value of all cash flows equal to zero. This method considers both the timing and magnitude of cash flows. In our example, we have an initial investment of one thousand dollars, additional investments of five hundred and three hundred dollars, and a final return of twenty-two hundred dollars. The MWR finds the rate that equates these cash flows to zero present value.
Time-weighted return eliminates the impact of cash flow timing by breaking the investment period into sub-periods at each cash flow date. For each sub-period, we calculate the return based on the portfolio value at the beginning and end, ignoring any cash flows during that period. These sub-period returns are then linked geometrically to produce the overall time-weighted return. In our example, we have three periods with returns of eight percent, twelve percent, and five percent, giving us a total time-weighted return of twenty-seven percent.
The key difference between these methods lies in their purpose and sensitivity to cash flows. Money-weighted return reflects the actual experience of the investor, including the impact of their timing decisions. In our example, it shows fifteen point two percent, which is lower because the investor added money when the portfolio was performing well. Time-weighted return shows twenty-seven percent, reflecting the portfolio manager's skill independent of cash flow timing. Use money-weighted return to evaluate investor performance and time-weighted return to evaluate portfolio manager performance.
In summary, money-weighted return and time-weighted return serve different but complementary purposes in investment analysis. Money-weighted return, being the internal rate of return, reflects the actual experience of the investor including their timing decisions. Use it when evaluating personal investment performance. Time-weighted return eliminates the impact of cash flow timing and focuses on the portfolio's inherent performance. Use it when evaluating portfolio manager skill. Both measures are essential for complete performance analysis, providing different perspectives on investment success.