There is more than one way to measure performance of an investment.
A time-weighted return reflects your portfolio’s investment returns.
And two forms of money-weighted returns — “simple return” and “internal rate of return” — reflect how much your deposits have grown over time.
Use our interactive tool to see the difference between time-weighted, internal rate of return and simple return.
Investors often want a simple answer to a seemingly simple question: how is my money doing?
While it’s relatively easy to calculate any one performance figure, understanding it and knowing how to use it can be more of a challenge.
When you log in to Betterment, we calculate the following return metrics under “Performance” for each of your goals:
- A time-weighted return
- Two money-weighted returns: simple return and internal rate of return
Here, we try to help you better understand each way of looking at returns, when you should use each measure, how to compare them, and the dangers of misunderstanding them. We even provide an interactive calculator (see below) that you can use to test with the different calculations.
Time weighted returns are the most common way investors will see a return communicated. A time-weighted return can be thought of as the return on the initial balance of an investment over a certain period. For example, investing $1 in the S&P 500 for one year. Common indices, such as the S&P 500, are reported in time-weighted returns.
Time weighted returns can refer to a price-only return, or a total return (price and income/dividends). Price returns reflect only the change in price of the asset, while total returns reflect both price and reinvested income. By default, Betterment displays total returns.
If you have an investment account in which you, the investor, control the cash flows into and out of the portfolio, and you want to judge the performance of the investments without the distortion introduced by your cash flow timing, you should use a time-weighted return. For that reason, it is the only method you should use to compare the performance of different investments or of a single investment against a benchmark, making it the industry standard return methodology for financial advisors.
Money-Weighted Returns: Two Measures
1. Internal rate of return
If you want to judge the overall performance of an investment including both investment returns and timing of cashflows, then you should use a money-weighted return. This is true if you use an investment manager who controls when cash is invested, or if you are managing cash flows yourself and wanted to check your performance.
The math gets more complicated here, but the concept is simple: When there is more money in the account, its performance is given more weight than when there is less. That way, an investment that has a lot of your money invested when your portfolio is appreciating, and then only a little when it is depreciating, will have that good timing (or good luck!) reflected in a money-weighted return.
It almost never makes sense to compare internal rates of return across accounts or managers, since it includes differences resulting from both your cashflows and differences in investment performance.
2. Simple Return
The return on an investment is most simply defined as the amount you gained as a percentage of the amount you invested. The simple return is a good back-of-the-envelope calculation that can work perfectly when you’ve only made a single investment, but in most common circumstances will not be a good judge of the growth of your portfolio.
If you invested $100,000, and after a year you have $110,000, you can safely describe your return as 10%.
But, consider what happens if you were to invest an additional $400,000 at the end of that year. Using the same calculation, you’d now find your simple return to be 2%. Did your investment performance suddenly drop by 8%? Thankfully, no. That is the major limitation of a simple return—it treats all of the deposits into an investment account as having happened at the same time as the first deposit.
Below is our interactive calculator which you can use to calculate each of these returns given different deposits at a few different points over the last 10 years.
Use this Calculator to Compare Return Measures
Calculate the differences in how return measures portray your investment performance by entering deposits and watching the metrics change.
For more information on Betterment’s approach to designing how your investment returns appear in our digital advice, read about our principled display approach.
Investing’s Pain Gap: What You Put Up with To Earn Returns
Markets are frustrating—especially when you look at a year’s worth of returns. Year to year, you can easily experience what we call the pain gap. The key is to not let the pain gap create a behavior gap between your account and market performance.
Betterment’s Model for Financial Advice: An Overview
Achieving your financial goals is only possible if you plan effectively. Saving enough, choosing the right accounts, deciding when you can buy a house or when to retire—all of these are essential decisions even before you build an optimal portfolio.
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