The Wealth Management Paradox—Part 2

Rate of Return: Which One?

To most people, it seems like a rather simple question, “What has my return been over the last two years?”  Not so fast. When you are reviewing your performance, keep in mind that there can be a huge difference between the performance of the investor and the performance of the investment.

Let start with an example:

Beginning of Year 1:

If you invested $100 in a mutual fund that was trading at $10 per share, you would own 10 shares:

  • Amount Invested: $100
  • Share Price: $10
  • Shares purchased: 10 ($100 divided by $10)

Over the next 12 months, the mutual fund doubled in price from $10 to $20 per share.

Beginning of Year 2:

With the investment at $20 per share, you make your annual investment of $100. So your investment at the beginning of year two looks like this:

  • Amount Invested: $100
  • Share Price: $20
  • Shares Purchased: 5 ($100 divided by $20)

At this point, you have invested $200, and you own 15 shares.

Over the next 12 months, the mutual fund falls from $20 to $10 per share.

End of Year 2:

  • Total Amount Invested: $200
  • Ending Share Price: $10
  • Total Shares Purchased: 15

How Did The Investment Do?
Over the two year period, the investment went from $10 to $20 and back to $10 per share.

So for the two-year period, the investment is even with a return of ZERO essentially. Most firms now send out a performance report, and given this example, most of them would report to that you are even. The investment went from $10 to $10, and that is EVEN. This is called a time-weighted rate of return (TWRR).

How About The Investor?
You started with $100 and added $100 for a total investment of $200. At the end of two years, you have 15 shares of a mutual fund that is worth $10/share. Your investment is worth $150. You invested $200 and you have $150.

DOES THAT FEEL LIKE EVEN? I am down 25%, please don’t try and tell me I am even! This is called a dollar-weighted rate of return (DWRR).

Using the Wrong Tool For the Job

I don’t think that this is an attempt to misrepresent or hide the truth. It is simply a problem of trying to measure temperature with a ruler. The investment industry (and even the financial planning industry to a large extent) continues to use tools that are great for managing investments but really provide very little useful information about how the investor is doing. The standard industry argument is that it is not their fault that you added money at the wrong time.

The investment manager should not be judged based on when you added or withdrew money. They should be judged based on how well they did ($10 to $10). This judgment makes sense if all you care about is returns. The returns manager’s value is to try (emphasis on “try”) to find investments with superior returns, and it makes sense to look at time-weighted rates of returns when comparing two investments. But to then tell me that I am even when I invested $200 and have $150 makes no sense at all.

RETURNS managers talk about, forecast, and report on INVESTMENT returns.

WEALTH managers talk about, plan for, and report on progress toward INVESTOR goals.

Next time you are discussing performance, remember that using time-weighted rates of returns to evaluate how YOU are doing is like trying to take your temperature with a ruler.

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