Measuring your rate of return (ROR) is not always straightforward. There are many types of ROR, and investors are not usually aware of their differences.
There are three measures of return that are frequently used: simple rate of return (SRR), internal rate of return (IRR), and time-weighted return (TWR). These measures all calculate performance differently.
Simple rate of return
SRR is the simplest measure of return, showing simply the percentage change in market value. It is often used to show how a benchmark or index performs over time because there are no cash flows over time that could affect performance. For an individual investor, however, SRR cannot accurately show the return of an individual’s investment portfolio.
Internal rate of return
IRR shows the performance of an individual’s portfolio between two dates, and it factors in the effect of cash into and out of the portfolio during the period. It is a more meaningful measurement of a portfolio’s growth than SRR. Since cash flows are worked into the calculation, greater weighting is given to time periods when more money is invested in the portfolio. IRR is sometimes referred to as the dollar-weighted return or personal rate of return. It can be affected by the size and timing of any contributions or withdrawals.
Time-weighted return
TWR captures true investment performance by eliminating the effects of contributions and withdrawals. It is the return on the very first dollar invested in the portfolio. The figure is arrived at by dividing up the performance period over short time frames and calculating the IRR for each interval. TWR is useful when looking at the investment performance of your manager and comparing them to a competitor or a market index.
Each of these measures is appropriate in certain contexts, but it’s important to understand that there’s no one-size-fits-all ROR. Understanding what each of these returns is designed to measure and how they differ will help you make better informed financial decisions.
Keep that in mind the next time you take a look at your account’s performance.