Smart Money: Seeing through rates
William C. Fisher
If the investment value drops, the time-weighted return over its whole life might be good but the average dollar invested loses money. Rates of return in successive time periods compound and do not average. The Bank Administration Institute established the time-weighted rate of return as the standard method for evaluating investment managers.
Rates of return are more complicated than we believe. Here's an example: If you have two investments combined 50-50 in your portfolio, and they realize 10% and 20% for the year, you can take their average to get your portfolio's return of 15%. But if it's only one investment for two years, and its rate of return is 10% in the first year and 20% in the second, you compound and annualize them to get the “average” annual return, which is lower than 15%.
Another example might be an investment is started with $100 which doubles in year one. You add another $100 in year two but the portfolio falls by 50%. Time-weighted ROR is 0%. Dollar-weighted ROR is -18%. The reader can readily see the importance of using the correct rates of return when monies are moving into and out of investment accounts.
To perform an effective rate of return evaluation, you need an effective asset allocation strategy coupled with realistic modeling. When performed by an investment consultant, this will give the CFO realistic rates of return expectations. And those results can then be used for future planning with a level of comfort that just combining numbers in any fashion will not do.