The money-weighted return is a performance measurement technique that calculates the rate of return on an investment by considering the timing and size of cash flows. This approach gives more weight to periods when larger amounts of capital are invested, making it a useful measure for assessing the impact of cash flows on overall investment performance. It can reflect the actual experience of an investor more accurately than other measures, particularly when there are significant variations in cash flow timings.
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The money-weighted return is also known as the dollar-weighted return, emphasizing its focus on cash flows rather than just time.
This return metric is particularly beneficial for investors who frequently add or withdraw funds from their investments, as it accounts for the actual investment experience.
To calculate the money-weighted return, one typically uses the internal rate of return (IRR) formula, which solves for the rate that equates the present value of cash inflows with cash outflows.
Because it considers the amount and timing of cash flows, the money-weighted return can be skewed by large contributions or withdrawals made at different points in time.
It's important to compare the money-weighted return with other performance measures like time-weighted return to get a complete picture of investment performance.
Review Questions
How does the money-weighted return differ from the time-weighted return in evaluating investment performance?
The money-weighted return considers both the size and timing of cash flows, giving more influence to periods with larger investments. In contrast, the time-weighted return focuses solely on the investment's performance over time without factoring in cash flows. This means that while money-weighted return reflects an individual investor's experience and decisions, time-weighted return provides a clearer picture of how the investment itself has performed irrespective of investor behavior.
In what scenarios would an investor prefer to use money-weighted return over time-weighted return for assessing their portfolio?
An investor would likely choose to use money-weighted return when they have made multiple transactions, such as additional investments or withdrawals, during the evaluation period. Since this measure accounts for the actual timing and amounts of these cash flows, it offers a more personalized assessment of how their decisions impacted overall returns. This is particularly relevant for investors who actively manage their portfolios, as their returns can significantly differ based on when they invest or take out funds.
Evaluate how external market factors could influence both money-weighted and time-weighted returns differently during volatile market conditions.
During volatile market conditions, external factors such as rapid price fluctuations can impact both money-weighted and time-weighted returns but in different ways. Money-weighted return may be disproportionately affected by large cash inflows or outflows made during high volatility, reflecting either substantial gains or losses based on timing. Conversely, time-weighted return will smooth out these impacts as it focuses solely on the investment's performance over specific periods without considering cash flows. Therefore, in turbulent markets, an investor could see a stark difference between these two metrics—money-weighted may show a poor performance due to ill-timed contributions while time-weighted may indicate steady growth.
A performance measure that calculates investment returns by eliminating the impact of cash flows, focusing solely on the investment's performance over time.
The discount rate that makes the net present value (NPV) of all cash flows from an investment equal to zero, often used to evaluate the profitability of potential investments.