Writing for The Globe & Mail, Preet Banerjee has a good column pointing out how different ways of measuring returns produces different results:
Time-weighted returns v dollar-weighted returnsAlthough a subtle point, I think it is worth tracking both, the time-weighted return and the dollar-weighted return. Most amateur investors, at least based on my observation on the Internet, only track the dollar-weighted return. Typically, many do this using a spreadsheet and computing the IRR (internal rate of return), or by using some online tool.
Let's assume that a portfolio has three years of 20-per-cent annual returns, followed by three years of 0-per-cent annual returns. The time-weighted return is 10 per cent on average for those six years. But this is not accurate if you only invested $1 at the beginning, and then added $100,000 at the start of year four.
The end value of this portfolio after six years would be less than $100,002, because while the $1 grew at 20 per cent per year for three years, the $100,000 didn't grow at all.
The dollar-weighted return in this case would be virtually nothing. That's in stark contrast to the time-weighted average return of 10 per cent a year.
Time-weighted returns can help you figure out whether the investment was a good one in hindsight, but dollar-weighted returns will help you figure out how well you are actually deploying your money in those investments.
I personally think it may be helpful to track both, especially if you are a concentrated investor since a few large positions can dictate your true return but doesn't indicate how good you are—your strikeout ratio. For example, my time-weighted return over the last 5 years or so, is around 3.95% per year, while the dollar-weighted return is around 0.8%. Neither of these returns are going to impress anyone but the dollar-weighted return may imply a far worse skill level than it seems. The gap between the two is very large because I saved a lot of money in the last few years and I have mostly been in cash (spectacular concentrated bet disasters, such as Ambac, also matter but less so than it seems). However, the success ratio, although not that impressive, isn't too bad. Of 27 investments I have made since I started investing, around 70% generated a positive return, with around 40% generating above a 10% cumulative return (not sure about annual return). Tags: insightful