How We Calculate Returns
Learn the different ways returns can be calculated, and find answers to common questions we hear from customers about their returns.
TABLE OF CONTENTS
- Time-weighted returns
- Money-weighted returns
- Other Considerations
- Time-weighted returns
- Money-weighted returns, which include:
- Simple earnings
- Internal rate of return
We’ll explain how each type of return works and outline the differences between them.
When people look at their returns, one goal is to understand how well Betterment is managing their money. If you want to judge how well Betterment has built your portfolio, the time-weighted return (TWR) is one of the most useful figures to use.
When you log into your Betterment account from a web browser and go to the Performance section, at the top right you’ll see your time-weighted return. If you’re logged in on the mobile app, tap “See performance,” and your time-weighted return will be listed first. We list it first because we want you to see if first, because for most Betterment customers, it’s one of the most useful numbers to look at to compare to how ‘markets’ are doing.
Remember that time is one of the most important factors when investing, especially over the long run. The time-weighted return measures how much the underlying asset mix in the portfolio is returning over a given timeframe. Of all the possible returns figures, it is the most reflective of how well we’ve designed your portfolio. When comparing it to markets or others returns, ensure you’re doing it fairly by aligning risk levels, the timeframe you’re looking at, and whether or not you’ve made allocation changes along the way.
How Should I Think About the Time-Weighted Return?
Time weighted returns can be thought of as the change in value your investments would have experienced if all the dollars you ever deposited were invested at the same moment as your very first deposit. Put another way, the time-weighted return can be thought of as the simple earnings for just the first deposit ever into an investment account.
The time-weighted return takes deposits and withdrawals out of the equation when evaluating your portfolio performance, and therefore is unaffected by deposits to and withdrawals from your account. Why would you want to see a calculation that does this? Because cash coming in and out of your portfolio at different times can distort and complicate your returns due to the nature of the constantly fluctuating stock market. And if you were comparing returns across two different accounts with two different cash flow patterns, you couldn’t be sure if the difference was due to the investments or due to the timing of the cash flows.
Ruling out cash flows makes it easier to understand how well your portfolio is doing, and allows you to fairly compare your Betterment portfolio with other investments. The time-weighted return is the industry standard investment return to compare performance across various portfolios and indices. Common indices, such as the S&P 500, are reported using the time-weighted return.
Because this return calculation removes the effect of specific deposits and withdrawals, two investors that start investing at the same time in an 80% stock portfolio at Betterment will have nearly identical time-weighted returns, regardless of their deposit or withdrawal patterns. Small differences will exist, arising from slightly different portfolio weightings due to portfolio drift, but generally, the difference in the time-weighted returns at the same stock allocation in the Betterment portfolio will likely be minimal.
The Relationship Between Dollar Earnings and Time-Weighted Returns
While the time-weighted return can be useful for assessing how well your portfolio manager is managing your portfolio, it is not as helpful in understanding how many actual dollars you as an investor are making in earnings through your investments.
Positive earnings but negative time-weighted returns.
An investor could consistently happen to make deposits when the market is low, only for the value of those securities to increase later in the future. In such circumstances, it would be possible for the investor to have positive earnings, even if the overall time-weighted return was negative.
Suppose you invest $10 to start, and then the securities in your portfolio go down 50% in value. Now you have $5 in the account. You then make a $100,000 deposit and the value of your portfolio goes up 10% immediately after that. In this case, you would have positive dollar gains, since you just gained about $10,000—much more than your initial $5 loss. It was not because the portfolio has performed well—in fact, your time-weighted return has been negative overall since you started, because it went down 50% and then up 10%. However, most of your money was invested right before a rally so, because of the timing and size of your deposits, you happen to have positive earnings.
Negative earnings but positive time-weighted returns.
On the flip side, an investor could happen to consistently make deposits while the market is at a high, before the value of the securities drops in price when the market falls. That investor would have negative earnings in dollars even with an overall positive time-weighted return.
Suppose you invest $10 to start, and the market gains 50%. Now you have $15 in the account. You then make a $100,000 deposit and the market goes down 10% immediately after that. In this case, you would have negative dollar gains, since you just lost about $10,000—much more than your initial $5 gain. It was not because the portfolio has performed poorly thus far—in fact, your time-weighted return has been positive overall since you started, because it went up 50% and then down 10%. However, most of your money was invested just before a drop, and because of the timing and size of your deposits, you happen to have negative earnings.
Note that these are extreme cases meant to illustrate the differences between the time-weighted return and other types of returns you may be looking at as an investor.
If you have an investment account for which you, the investor, control the cash flows into and out of the portfolio, and you want to judge the performance of the portfolio without the timing and size of your cash flows, you would use the time-weighted return. Because this is the only return that takes cash flows out of the equation, it is the preferred method you should use to compare the performance of different investments against a benchmark. It’s the industry standard return methodology for financial advisors.
Money-weighted returns are affected by every cash flow that goes in and out of your portfolio. Cash flows at Betterment include deposits, withdrawals, dividends, and fees.
We provide two types of money-weighted returns figures: simple earnings and internal rate of return (IRR).
Your simple earning is simply the ratio of the earnings in your account to your net deposits. Earnings include market changes (in either a positive or negative direction), dividends, and fees. Your net deposits are your deposits minus your withdrawals over a given time frame.
Simple Earnings = Earnings ÷ Net Deposits
Because your simple earning is easy to calculate, we know it can be tempting to use it to judge your portfolio’s performance—but in fact, it can be quite misleading. When you see simple earnings, I want you to think, “This is like when I was a kid and my mom asked me if I’d brushed my teeth, and I said yes, which was technically true, but only because I brushed my teeth yesterday. It was technically not dishonest, but also did not address the heart of the question at hand.” That is similar to simple earnings. It’s a real number, we’re not making it up, and it’s not technically inaccurate (whatever “inaccurate” means). But it also probably does not really address the question you were trying to answer in the first place.
Here’s an example to illustrate why simple earnings can be misleading:
You deposit $10,000. Then you earn $2,000. Wow!
Simple Earnings = Earnings ÷ Net Deposits
$2,000/$10,000 = 0.2 = 20%
Your simple earnings is now 20%. That sounds really good!
Now, you decide to withdraw it all. Maybe you want to buy a course to further your education. Or, you intend to pay four months’ worth of your child’s New York City day care costs. Perhaps you’d like to buy three-fourths of a 2018 Toyota Camry. Whatever the reason, you withdraw all $12,000.
What are your simple earnings now?
Simple Earnings = Earnings ÷ Net Deposits
$2,000/($10,000-$12,000) = $2,000/-$2,000 = -1 = -100%
Your simple earnings are now negative, even though your actual earnings were the same. This is because the simple earnings calculation is easily distorted by cash flows—especially withdrawals.
Simple earnings is the only returns figure that most people can easily calculate on their own, and it gives some people peace of mind to be able to fully understand and calculate at least one of their returns figures themselves. Calculating other types of returns would require a ton of backend data on market changes, dividend payment history, and cash flows in your particular accounts—not to mention the right software and code to compile this data correctly. Because the other return types are so difficult to calculate, we suggest letting our algorithms do the work for you.
In previous Betterment history, we considered removing simple earnings from the Performance section completely, because of how easily it can be distorted and cause confusion. But, customers pushed back. They felt we were taking information away from them. We want to be transparent, so we left it. But we want you to understand it doesn’t mean you have clean teeth.
Internal Rate of Return (IRR)
The other money-weighted return figure displayed in your account is the internal rate of return, or IRR for short. It is certainly more useful than the simple earnings figure. But, it is also not the best figure to use to understand how well Betterment is managing your money (TWR is), because it includes the impact of your deposits and withdrawals.
IRR does a better job of answering the question, “What are the average returns on the dollars I personally deposited into Betterment?” as opposed to “How well does Betterment design and manage the portfolios I have with them?”
In other words, the time-weighted return tells you about the performance of the underlying portfolio itself, while the IRR tells you about the degree to which you benefited from the performance of that portfolio based on the time frame in which you were invested in it.
Here’s an example to help explain how IRR is affected by your cash flows, versus the underlying portfolio itself:
Let’s say there’s a statistic that says Denver, Colorado is sunny for 250 days a year on average. That’s about 70% of the days in a year. But you went on a trip to Denver for five days, and it was overcast for four of the days you were there. In your personal experience of Denver, it was only sunny 20% of the time, in contrast with its average rate of 70% sunny days.
If you wanted to describe the general weather in Denver, it would make more sense to describe it using the 70% sunny days statistic, not your personal 20% sunny days experience. If you were to describe your experience with Denver on your trip, you would say Denver was only sunny 20% of the time, which was largely based on luck around when you were there.
In this weather example, the average of 70% sunny days in Denver is analogous to the time-weighted return. The 20% sunny days that you experienced during your five-day trip is similar to your IRR for a given time period. It’s personalized, and it matters to you, but it doesn’t fully describe the weather in Denver, and it shouldn’t inform what you should expect weather in Denver to be like in the future.
The date you traveled to Denver is similar to when you decided to make a large deposit into your investment portfolio. The IRR figure is affected by your deposits and withdrawals. Your simple earnings are also affected by your deposits and withdrawals, but IRR does a better job of describing your returns than simple earnings, because it’s sensitive to the amount of time that your dollars were invested. IRR gives more weight to returns on dollars that have been invested for longer. IRR can be useful, especially in comparison to TWR. But, for most investors at Betterment, IRR is not the return figure that answers the question they are trying to answer.
IRR tends to be more relevant for investors if their portfolio manager is not only choosing what they’re invested in, but also when securities are bought and sold. We don’t do this at Betterment, because we buy and hold ETFs when you deposit. Our investing philosophy is a passive, long-term investing strategy, which has been shown in research to generally outperform most active portfolio management strategies. At Betterment, you control the timing of your deposits and withdrawals, not us, so your IRR will tell you more about the luck you had regarding when you made your largest deposits and withdrawals.
Another example of IRR and when it can be helpful:
An example of when IRR might be the most relevant measure of performance can be found in the hedge fund depicted in The Big Short, a film about the 2008 financial crisis and the investors who predicted it would happen.
If you’re not familiar with the story, here’s a quick rundown: The creator of the hedge fund, Dr. Michael Burry, believed a large amount of individual mortgage loans were going to start defaulting in about two years, and that the bonds backed by those loans would therefore also fail. He chose a specific point in history to buy securities for his investors that would increase drastically in value if his effective “bet” against those mortgage-backed bonds was correct. In buying these securities, he effectively bet against the mortgage bonds when everyone else still thought the bonds were safe.
Once it became apparent years later that the bonds were not safe, the value of the securities he bought for his investors drastically increased. For years, he sat in cash and his investors had a low IRR. Then, in just a few months, the IRR changed drastically. When comparing fund managers like Dr. Michael Burry’s hedge fund company, IRR becomes a lot more relevant.
Most Betterment investors are not comparing investment managers that have this level of control over their assets, so the time-weighted return continues to be the most useful figure in understanding how well Betterment is managing your portfolio.
If Your Money Is Growing, Time Weighted Return Usually Grows Faster
One more note on IRR versus TWR: Suppose you are auto-depositing on a regular basis while the market is going up—what would you expect your IRR and TWR to be?
Your IRR will be lower than your TWR because each new auto-deposit hasn’t grown as much as the previous ones. It can be frustrating to continuously feel like you are underperforming over time as you auto-deposit, but it’s actually a sign you’re doing things right.
In the graph below, the darker line representing time-weighted return is an estimate of what a portfolio would have returned if all future deposits were invested into an account on day one. Notice how greatly the line varies from the lighter colored line, which depicts simple earnings.
Source: Time-weighted returns and earnings for a hypothetical portfolio with $10 monthly deposits into U.S. Total Market fund (VTSMX). Data from Xignite, analysis by Betterment.
But remember, returns are not the only thing that matters.
It’s also important to consider that, while the time-weighted return may be the most helpful type of return figure to use when evaluating your portfolio manager, there are many other factors you should consider when evaluating your portfolio manager. Taxes saved now or at withdrawal from our services like TaxMin, Tax Loss Harvesting+, or Asset Location aren’t reflected in pre-tax returns. Also, you should not expect your time-weighted return over a short time horizon to be representative of the performance of your portfolio manager.
As with any data, the larger the sample size, the more representative the information you’re looking at. To consider a long enough time frame in considering the performance of a portfolio, a good rule of thumb is to look at the annualized time-weighted return over 12 or more years. That may seem like a lot, but market trends are bound to flip — even after stretches of consistent performance over a few years — so even looking at returns over a period of five years leaves your guess at which portfolio manager is performing better largely up to chance.
Arguably even more important than being invested in a well designed portfolio is how long you are invested in that portfolio. Research on returns in the S&P dating back to 1928 suggests that how long your funds are invested is generally one of the most important factors in achieving high returns.
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