I won’t bury the lead…
Dollar-weighted returns – BAD.
Time-weighted returns – GOOD.
Here’s why:
You invest $100,000 and it grows to $200,000 over 10 years.
But in year 11, the market stinks and you lose 10% leaving you with $180,000.
Your annualized return is now 7.3%, which is BOTH your time-weighted AND dollar-weighted return.
Let’s change it up a bit.
You still invest $100,000 and it still grows to $200,000 over 10 years.
But in this scenario, you’re so excited by the money you’ve made, you invest $1,000,000 MORE… right before the downturn.
After the 10% drop, you have $1.08M. You’ve now lost $20,000 in total over 11 years.
Your annualized dollar-weighted return is now -1.08% per year
But your time-weighted return is STILL +7.3% per year!
“Wait, I can lose money with a positive return!?”
Yup.
Dollar-weighted returns take into account cash inflows and outflows.
In other words, it just annualizes your absolute return – what you put in and what it’s worth now.
So depending on your timing, you could look like a genius or a complete failure.
Time-weighted returns, on the other, hand only look at the underlying portfolio performance regardless of cash flows.
It normalizes your investment returns, so you can ascertain the underlying foundations of the portfolio (which we can control) instead of the outcome of your market timing (which we can’t control).
In other words, the time-weighted return tells you if you’ve got a good cookie recipe.
The dollar-weighted return tells you if the batch you just made was good or bad.
FOR MY SUPER NERDS: I’m aware that my DWR and TWR calculations are not up to code. That’s not by accident. I wanted to simplify the math to simplify the concept.
