If you ask the average person on the street how to find out if a stock has gone up or down, how do you think they’d respond? “Google” is probably the most likely response, but others might mention Yahoo Finance (a legacy product from the Web 1.0 firm that is still going strong), or maybe they might mention an app provided by a brokerage like Robinhood (HOOD) or Schwab (SCHW).
All of these answers are wrong.
If you look up a company like AT&T (T) on Google and choose the YTD option, you’ll see a 15.7% decline. That’s not great—but it’s also not true. Note that T pays out dividends and at a pretty high yield—over 8% right now. Since this is a price return and not a total price return (i.e., with dividends included), it’s not an accurate representation of the stock’s real return in 2021—that would be -7.2%, if you include dividends. Not great for sure, but a lot better—and more accurate.
This still isn’t totally accurate, because we aren’t considering dividend reinvestments—if you take that dividend and reinvest into the stock, your return will be slightly different than if you take the dividends as straight cash. So even this isn’t the most accurate measurement of an investment return.
And things get more complicated when you start looking at portfolios. At this point, we need to talk about time-weighted versus money-weighted returns.
Time-weighted returns (TWR) ignore cash flows from deposits and withdrawals into the portfolio, thus includes only the performance of the investments themselves. If I start the year with $100,000 in an account and end with $120,000, but I also deposited $10,000 in the middle of the year, my TWR is 10%, not 20%. TWR is obviously the most important method of determining the quality of a portfolio’s investments and is thus the gold standard for measuring whether your fund manager or advisor or whoever is making the investment decisions is doing a good job. The formula is quite simple:
TWR = [(1+HP(1))*(1+HP(2))*…(1+HP(n)]-1
where
n = periods
HP = Terminal Value – (Starting Value + Cash Flow) / (Initial Value + Cash Flow)
Money-weighted returns (MWR) are much more complicated and are usually solved with the use of a financial calculator or spreadsheet as opposed to a simple formula. MWR will incorporate cash flows to determine the overall performance of an investment, which makes it extremely useful in some cases and useless in others. For instance, a retiree steadily adding money into a retirement account will see significant growth thanks to an MWR calculation even if the TWR is low (or negative, in some cases) as long as the contributions exceed the market performance of the investments by enough of a margin. Thus MWR can mask bad investments and should not be used by initial investors (it is thus frustrating that most discount brokerages use MWRs as a default display, but it is noteworthy that this often artificially inflates returns and makes individuals feel like they’re making more progress).
At the professional level, the MWR is much more useful in tandem with TWR because it demonstrates how the fund’s liquidity and cash needs are impacting the portfolio’s performance. Take, for instance, a pension fund that has a rising amount of payouts in certain parts of the year due to the random distribution of ages amongst its investors—knowing the MWR in this case will be absolutely crucial to improving portfolio performance and making liquidity preference recommendations.
When the year ends and people ask themselves, “how well did I do this year?”, the answer to that question is surprisingly much more complicated than many realize or consider. Thus when you hear a friend brag that they made a big profit in the markets this year, take it with a grain of salt—or better yet, ask them what methodology they used to reach that conclusion.
