Part 1: The rate of return on my investment doesn’t add up. Help!
“How are my investments doing?” That’s the million-dollar question for any investor. If you’ve ever opened an investment statement and struggled to understand it, you’re not alone. Numbers don’t lie, but sometimes they obscure the real story; a too-narrow focus on returns (or not understanding the different ways we can measure returns) is one of the pitfalls of DIY investing.
Fortunately, you can rely on the fine folks at WealthBar to show you how to make sense of your investment return. Let’s do this.
Not all rates of return on investments mean the same thing
That said, it’s not that complicated. Your actual rate of return will most likely be measured in one of these four ways:
• Simple Rate of Return
• Compound Annual Growth Rate (CAGR), aka Annualized Rate of Return
• Time-Weighted Rate of Return, aka Geometric Mean Return
• Money-Weighted Rate of Return, aka Internal Rate of Return
(If you’d like to see a more detailed breakdown of how these are calculated, see our upcoming article, How are the different types of investment returns calculated?)
You measure the rate of investment return differently based on which kind of investment account you use. For example, in Canada the Money-Weighted Rate of Return is the standard for returns of investment accounts (your RRSP or TFSA).
Meanwhile, the Time-Weighted Rate of Return is the standard for returns of Money-Weighted Rate of Return investment funds (the ETF or mutual fund in your account) and indexes (TSX).
Comparing the Money-Weighted Rate of Return of an investment account to the Time-Weighted Rate of Return of an investment fund (even if it’s in the same account) is an apples to oranges comparison. That’s a common mistake many investors make when evaluating performance.
If you invest money in an account in a particular fund, you may very well see your own personal return for that account (Money-Weighted Rate of Return) vary from the return reported by the fund you own (Time-Weighted Rate of Return)!
Which Rate of Return should you use when describing your investment?
As you might expect from our introduction, that depends on the type of investment you are talking about.
For example, did you make an initial deposit to an investment without any additional deposits, withdrawals, or income from the investment? By looking at the investment value at the end of some period of time, you can easily understand your rate of return.
In the real world of investing, most of your investments will have multiple deposits or withdrawals (cash flows) over time. The different ways to calculate rate of return can produce wildly different results for the exact same investment because of how they account for your cash flows.
If you’re in that situation, here’s how you simplify matters to understand your real rate of return:
Comparing investments that are made at the same time with a single deposit and no additional cash flows?
Use either the Simple Rate of Return or Compound Annual Growth Rate.
Need to understand how one investment has fared compared to another, or to a benchmark, over different periods of time?
Then use the Time-Weighted Return.
Evaluating the performance of an investment account with multiple cash flows?
Use the Money-Weighted Return.
What if you do not have control of the cash flows for an investment?
The Time-Weighted Return works well here (as is the case with a mutual fund or ETF, for example). However, if you do have control of the cash flows for an investment (as is the case with an investment account that may hold multiple investments) then the Money-Weighted Return is best because it does the best job accounting for cash flows.
Which rate of return does WealthBar use?
WealthBar uses the Money-Weighted Rate of Return to show our clients their personalized performance.
Why do we do this? The Money Weighted return is based on how you contribute to (and withdraw from) an account, giving you the best understanding of your personal performance.
Looking for get more into the actual number on how this is calculated? We go beyond the theory and run the numbers in Rate of Return Part 2. How are investment returns calculated?
Still unsure how your investments are doing? Book a call with a WealthBar advisor if you’d like help making sense of the performance of your WealthBar portfolio or other investments.