Where: MV0 = beginning market value, MV1 = ending market value, D1 = dividend/interest inflows, CF1 = cash flow received at period end (deposits subtracted, withdrawals added back)
Yikes! Math! Well, it's kind of important when determining how your investments are doing. There are two popular measures of investment performance - TWR (Time Weighted Return) and IRR (Internal Rate of Return sometimes referred as Money Weighted Return).
TWR is good for comparing two investment managers to see how one performed against the other while not penalizing for money put into or taken out of the account. It evens the playing field for that purpose.
However, for the purpose of "how did YOU do", IRR is likely a better tool.
Suppose a client had $5,000 with the manager the first year and earned 10%. The second year, the client added, another $5,000, but lost 8%. At the end of the second year, the investor would have $9,660, less than the total investment. Overall, the client is down $340. However, the time-weighted return would still be 1.2%.
This can be quite confusing, as clients will wonder how there can be a positive return when they lost money. Explaining that it is just “the way time-weighting works” is not likely to win the trust of a client who has lost money.
Alternatively, the money-weighted return for the example above, where the investor lost money, would be -2.3%, which is a far more intuitive return when money is lost than the +1.2% calculated using time-weighted return. The 1.2% tells the investor how the manager did, eliminating the impact of the cash flow that was introduced in year two. The money-weighted calculation, however, tells the investor how his or her money actually performed.
Now, for the potential problem. Suppose you are a financial advisor sitting in front of your client and have the choice when running their report to show them the Time Weighted return of +1.2% or the client's real return of -2.3%. Hint: Your reports will usually show TWR or IRR on them beside the return value.
I think it is much more important to understand if you are gaining ground toward your goals or not.