- Understanding your percentage of return
Although there are multiple ways to calculate returns for any investment, in order to account for time and deposits, most investors ultimately simply want to see how much money they currently have versus how much they started with.
The approach that we use to calculate such return percentages is the Time Weighted Return (TWR) approach. You should think of TWR as the return your portfolio generated assuming all your deposits were made on the first day your account was opened. This calculation method eliminates the effects of your deposits and withdrawals, and instead looks at the portfolio performance itself, with each day weighted equally regardless of whether the account has $100 or $1,000,000.
This is not the same as dividing the total gains or losses by the initial portfolio value, which is the simple percentage return. Check out the bottom of this article to see why the simple percentage approach may be misleading, particularly when taking deposits and withdrawals into consideration
Now that you understand what this number is, it’s important to note how your deposits and withdrawals affect the relationship between your total earnings and your TWR.
- How your earnings may be positive but your TWR could be negative
Because you might have deposits and withdrawals on different dates, showing you a simple percentage return might not be sufficient. The example below will explain:
Let’s say Sarah made a $2,000 deposit, and her portfolio dropped by 50% so she’s left with $1,000. Then, Sarah makes a $30,000 deposit so her portfolio balance goes to $31,000. Soon after, the market rallies and her portfolio grows by 10% to become $34,100 ($31,000 + $3,100).
Overall, Sarah has $2,100 in gains for her portfolio (she lost -$1,000 then made +$3,100).
However, if you consider the actual percentage returns for each period, the portfolio was down 50%, then gained 10%. Using simple compounding according to the TWR method, her portfolio has a TWR of (((1-50%) x (1+10%))-1) = -45%. Note that because of the timing of her deposits, she has positive gains but negative TWR.
- Negative earnings but positive TWR
The same dichotomy can be seen if the scenario was reversed.
First, Sarah’s $2,000 deposit grew by 50% to $3,000, then she deposited $30,000. Her new balance is now $33,000 ($2,000 + $1,000 + $30,000)
Her portfolio then lost -10% ($3,300) so she now has $29,700.
Overall, she lost -$2,300 (made $1,000 then lost $3,300).
However, her portfolio actually performed well from a daily return perspective, growing by 50%, and then dropping by 10%.
This is why we use the TWR method; it captures the real performance of your portfolio, weighting each period equally regardless of market value, eliminating the effects of deposits and withdrawals.
- Why we don’t use the simple percentage return, and how it can be misleading
The simple percentage return is calculated by dividing your earnings by your net deposits.
So for example, if your net deposits are $5,000 and you earned $1,000 your percentage earnings will be:
$1,000 / $5,000 = 20%
Now let’s say you decide to go on a trip, so you withdraw $3,000, and your balance becomes $2,000.
The simple percentage return would now be:
$1,000 / $2,000 = 50%
You can see why this number can be quite misleading, because technically this hypothetical portfolio did not ‘grow’ by 50%.