This is a common question we receive. Over the years, a frequent method I’ve observed investors use to answer this question is a simple rate of return, generally known as a holding period return. But there are two other methods available, and for various reasons I’ll show below, they are usually more appropriate to use.

Holding Period Return (HPR)

Also referred to as your cumulative return, this value does not take into account the impact of time (did it take 1 year or 9 to earn the return?), and does not adjust for the impact of what dollars were invested, and when. It is generally reported as a single return percentage.

Internal Rate of Return (IRR)

This method requires more data, but it takes into account the impact of time, when you contribute to or withdraw (your principal) from the investment, and when you receive money from the investment (capital gains, dividends). A general principle in finance is that if you have control over when the money is invested, this is the most effective measure of your investment return. Additionally, all return values should generally be reported as compound annual values (geometric returns), and not just as a cumulative, single return value.

Time Weighted Return (TWR)

Using TWR as a measurement is more effective when evaluating one specific investment, portfolio, or benchmark’s returns to another for comparison. For investors in a specific investment, it is this method that is most consistent with the Chartered Financial Analyst Institute’s principles of integrity and professionalism, as this method would give the most meaningful rate of return values for clients to check their fund’s performance in a like comparison.

This method is similar to an IRR calculation, however TWR removes the impact of the timing of your additional contributions/withdrawals, and simply seeks to measure the performance of an underlying investment. It is best at measuring the performance of the very first dollar invested, and is most effectively used when comparing two investments where the cash flow timing was not necessarily controlled. If just one investment is made, its TWR and IRR will be identical.

It is not, however, effective at telling you the true performance of all of your investments adjusting for your specific cash flows (in or out of the investment/portfolio). If you needed to earn a specific rate of return over time and under varying accounts and scenarios, you should use IRR to see if you have met your minimum hurdle return rate assumed necessary to meet your financial plan goals.

Universal Ethical Standards, How We Report

For practitioners of finance, something as simple as reporting a rate of return is a deep ethical responsibility. If misused, it could convey or imply more return than were present to the self-interest of an investment advisor, or inversely under-report the performance of another advisor with similar implications. In particular, investment returns are most helpful when they have further context, including portfolios of investors similar to you, or benchmarks making up the total investable universe of assets with a similar risk profile as yours.

“You must be the change you wish to see in the world.” – Mahatma Gandhi

At Callahan Financial Planning Company, we work diligently to report to clients in a way that gives them a reliable and honest depiction of what they have and what is reasonable, generally including a presentation of IRR and TWR at periodic intervals, in addition to offering a cumulative return when sought by a client. We report to our clients in ways we would want to receive reports ourselves.

Bottom Line

We follow the following principles when reporting:

• We report investment returns net of all fees (your rate of return received after all costs have been deducted)
• We report returns greater than a one year period as a compound annual return (CAGR/geometric returns), unless stated as cumulative
• We provide our best estimate of reasonable returns to expect in the future, and will not inflate the number to earn new business
• We may provide additional return values (cumulative or gross of fees, for example) for additional transparency, but will only do so when the proper returns are also made available to a client
• We will not modify the way we report to clients to make our returns look better than they really are

Author: William A. Callahan, RLP, CFA, CFP®

William founded Callahan Financial Planning and previously served as President of the firm.

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