In the world of finance and investing, measuring the success of your investments is crucial to making informed decisions. Two key metrics that investors often rely on are Return on Investment (ROI), sometimes also referred as simple return, and Time-Weighted Return (TWR). These metrics offer valuable insights into the performance of an investment, but they each address different aspects of that performance. In this article, we will delve into what these metrics are, how they differ and, how they work in action.
Return on Investment (ROI): The Basics
Return on Investment (ROI) is a fundamental metric used to assess the profitability of an investment. It’s a ratio that quantifies the gain or loss generated on an investment relative to its cost. The formula for calculating ROI is:
ROI=(Current Value of Investment−Cost of Investment)/ Cost of Investment × 100
ROI is usually expressed as a percentage and provides a simple way to compare the efficiency of different investments. It’s especially handy when evaluating shorter-term investments.
Understanding Time-Weighted Return (TWR)
Time-Weighted Return (TWR) is a more advanced metric that takes into account the impact of cash flows and the timing of those flows on investment performance. TWR aims to provide a more accurate representation of an investment’s true performance, especially when there are contributions or withdrawals made during the investment period.
TWR is calculated by compounding the sub-period returns over the entire investment horizon. This method eliminates the bias that could arise from uneven contributions or withdrawals, which might distort the overall return.
Differences and Benefits
- Inclusion of Cash Flows: One of the most significant differences between ROI and TWR lies in how they treat cash flows. ROI doesn’t consider cash flows made during the investment period; it only focuses on the initial investment and the final value. TWR, on the other hand, accounts for the impact of cash flows, providing a more accurate picture of the investment’s performance.
- Effect of Timing: ROI can be heavily influenced by the timing of cash flows. For instance, a large contribution during a period of high returns might inflate the ROI, even if the investment itself performed moderately. TWR, being time-weighted, reduces the impact of such timing discrepancies, offering a more realistic assessment of performance.
- Suitability for Comparisons: ROI is useful for comparing the performance of different investments, especially when the investment periods are relatively short. TWR, however, is better suited for comparing investments with varying cash flows over longer periods. For example, if you want to measure your portfolio’s overall performance, you most likely want to use TWR to exclude the cash flows.
- Use Cases: ROI is often used to evaluate single investments or projects. TWR is preferred for assessing the performance of investment portfolios, mutual funds, or other pooled investments, where cash flows are common.
Example
Imagine you invest $10,000 in a mutual fund on January 1st. Over the year, the value of the mutual fund fluctuates due to market changes. Additionally, on July 1st, you decide to add an additional $5,000 to your investment. By the end of the year, your investment has grown to a total value of $16,500.
ROI Calculation:
- Initial Investment: $10,000
- Added investment: $5000
- Final Value: $16,500
- Net Profit: $16,500 — $15,000 = $1,500
- ROI = Net Profit/Cost × 100 = 1500/15,000 × 100=10%
So, according to the ROI calculation, your investment has grown a total of 10% over the entire year. That’s awesome!
Not let’s assume you add $1000 to your investments on the last day of the year. If the value of your investments would not change your ROI would be now $1500 / $16000 * 100= 9.375%. As you can see, your ROI is now smaller, even though the net value of the fund did not change and the net profit is the same. As stated, the inflows and outflows of money from your investment account have a huge impact on ROI.
Time-weighted return calculation
For TWR calculation we need to use a new sub-period for each time there is a change in cash flows. For simplicity, let’s assume that the mutual fund’s value was as follows:
- January 1st: $10,000
- July 1st: $10,500 (Value before adding $5,000)
- December 31st: $16,500
Now, let’s calculate the sub-period returns:
- Return from January 1st to July 1st: (10,500−10,000)/ 10,000 × 100 = 5%
- Return from July 1st to December 31st: (16,500−15,500) / 15,500 × 100 = 6.45%
TWR is calculated by compounding these sub-period returns: TWR=((1 + 5/100) + (1 + 6.45 / 100) — 1) × 100 = 11.77
So your time-weighted return is 11.77%.
If we would add another $1000 into the investments as we did in the ROI example, we would simply add a third sub-period into the equation.
Conclusion
As we can see ROI and TWR have different approaches to calculating profits. Whereas ROI measures the rate of return, TWR focuses on the cumulative returns. Choose your metrics wisely when determining how much your portfolio has grown!
In Stockle you can compare your investment portfolio returns using both approaches described.
If you want to measure individual investments ROI is a simple method of calculating your returns. Then again if you are measuring the overall performance of your portfolio, TWR can provide more accurate results as the effect of cashflow is excluded.
