Account Balance vs. Time-Weighted Return

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One of my friends and I were recently talking about investments. They confided in me that their assets were already recovered to pre-COVID levels, but then asked:

How are my assets already recovered when the indexes I’m investing in have not yet?

In market downturns, often the newest investor reports recovering the fastest due to a simple reporting error.

If you are looking at recovery in terms of total dollars in your account and your new contributions are a large portion of your portfolio, then your contributions alone can pull your account balance up to a pre-drop level without market returns actually doing anything. In this way, your account balance chart may already look like a V-shaped recovery even if the markets have not recovered yet or maybe even at all.

In the same way, if you are looking at the dollar amount while you are withdrawing from your portfolio, you may never see the recovery even if it happens, as your account balance will go predictably down alongside your regular withdrawals.

For this reason, looking to your account balance or other accounting numbers as a sign of investment returns is a mistake.

Instead, investment reporting uses a time-weighted return. A time-weighted return attempts to eliminate the effect of contributions or withdrawals from the return calculation. In this way, it is the best return to use when trying to compare one portfolio’s performance to another portfolio or a benchmark.

A time-weighted return is found by calculating the return both before and after a cash flow and then stringing all those smaller time-period returns together until you have calculated the full return. Although it is difficult to do by hand, it is easily accomplished with investment reporting software.

In this way, even if you contribute more to your account right before a large investment drop, the investment loss is fully measured even though the account balance may end higher than it started before your contribution.

Newer investors tend to use simpler investment reporting techniques that they can do by hand. They also tend to be contributing large amounts to their newly created accounts. Together, these two facts mean that newer investors tend to report larger gains, faster recoveries, or less losses for their portfolio than the funds they are invested in.

Although they are correct that their account has that much more in it now than it had before, the numbers quoted are often not ones that legitimately can be used to compare to other portfolios.

That being said, the investor who diligently contributes to their portfolio even though the markets are down has done something courageous and worth applauding. Investing at a time of maximum pessimism, especially with your first dollars, is a contrarian move that often pays off as the future expected return is larger the lower the market falls. And investing during a trough means that when the market does recover your portfolio has gains from your purchases in the trough.

As part of our service to clients, we provide quarterly reports showing information pertaining to your asset allocation, changes in your portfolio, performance summary by asset class, your portfolio value versus cumulative net investment, contributions and withdrawals by year, yearly performance summary by asset class, and information on our fee for that quarter. The performance sections show the time-weighted return net of fees for each of our asset classes as well as the portfolio as a whole for various time periods including since inception.

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Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. Her most popular post: The Complete Guide to Your Washing Machine