“Put all your eggs in the one basket and—WATCH THAT BASKET.” Mark Twain

Though Mark Twain’s allocation brilliance did not match his literary brilliance, he did get right the importance of watching one’s investments. The two chief reasons to watch that basket is to evaluate the effectiveness of one’s investments and to assure one is meeting financial goals. Both these ends are equally important in the fiduciary world—whether the investment be an endowment, survivor trust, or pension fund. But the problem is how to watch that basket. Unfortunately, I generally find investors using the wrong measures for the wrong reasons when it comes to watching their basket. The end result can sometimes be making very wrong decisions and taking imprudent actions. The aim of this article is to help rectify just that.

There are three primary ways to measure investment performance, each which serves a different purpose: gain/ loss, dollar weighted return, and time weighted return. Gain/ loss is calculated by simply taking the difference between the current value and the cumulative investment purchases made. For a taxable account, this is equivalent to the so called unrealized tax loss. Dollar weighted return is also known as the internal rate of return and is the constant annualized return that would generate the ending wealth or deficit given the cash flows (i.e., deposits and withdrawals) and when they occurred in the investment. Time weighted return is the annualized rate of return that would have been realized independent of when cash flows occurred. If there is no cash flow other than an original deposit, the time weighted and dollar weighted return are the same. However, if any money is added or taken away, they generally diverge in value. We will begin with a stylized example to illustrate how all three of these measures can be different and lead to very different assessments of an investment..

Let us assume Fiona Fiduciary invested $100 in an endowment fund. Let us say this endowment fund grew to $200 one year later. Just then she received another $800 contribution, which she happily added to her high performing endowment fund. After the second year, however, her endowment fell to $800. How did her investment do?

Well, if we use gain/ loss, we see she suffered a $100 loss or 12.5% of the current value—i.e., $800 current value minus $100 of original investment minus $800 of an additional contribution.

If instead we use dollar weighted return, this must calculated numerically, as there generally are no closed formed solutions. For most cases, however, an Excel sheet with the IRR function will do the trick. This yields an approximately 10.1% annualized loss per year for Fiona.

Finally, if we calculate the time weighted return, we do so by simply “linking” annual returns together and then annualizing this figure. For example, Fiona enjoyed a 100% return her first year (i.e., $100 grows to $200). However, her second year she had a 20% loss (i.e., $1,000 fell to $800). Thus, her total return was (1+100%)*(1+-20%)-1=60%. Annualized, this yields roughly (1+60%)^(1/2 years)=26.5%.

So how did her investment do? It did great!

How did she do? She did horribly!

So what happened? What happened is she invested a large amount of money just before the investment had a poor performance period. However, if she would have invested the entire $900 (i.e., $800 and $100) from day 1, she would have had an account worth 900*1.6=$1,440. This underscores the importance of tracking both figures—both dollar and time weighted return. It should then be clear, we should use the time weighted return to evaluate the efficacy of her investment, as her investment does not control when Fiona adds or takes away money. However, we need to use the dollar weighted return to help make sure she is meeting financial goals. Her financial well being really was a 10.1% annualized loss. When using a benchmark such as a market index or peer group return, it is only appropriate to compare this against the time weighted return. For the dollar weighted return, the financial goal target return is the appropriate benchmark.

And what about the gain/ loss? This measure is almost never appropriate to measure investment performance unless only one thing is invested in and money is never paid out or reinvested. Gain/ loss should really be used for tax management. To see the problem of using gain/ loss in performance measurement, consider another example. Let’s say an endowment purchased a $100,000 investment. This investment then paid over the course of a year $2,000 of dividends and then a year end capital gain of $5,000. If these are reinvested, the basis then becomes $100,000+$5,000+$2,000=$107,000. If the fund then ends the year worth $105,000, the gain/ loss shows a $2,000 loss, or 2%. However, the investment actually made 5%!

So in short, hopefully this simple example has illustrated investors aren’t necessarily doing as well or bad as their investments, and is up to a fiduciary to know the difference and why. The good news is any competent investment management consultant should be providing all three measures and helping clients navigate their way through properly watching their basket(s). Should you have any further questions, as always, please feel free to write or call.

Dylan B. Minor MS, CFP®, ChFC, CLU, CIMA®

Chief Investment Officer

***The solutions discussed may not be suitable for your personal situation, even if it is similar to the example presented. Investors should make their own decisions based on their specific investment objectives and financial circumstances. It should not be assumed that the recommendations made in this situation achieved any of the goals mentioned. This example is hypothetical and does not represent any specific investments or strategies.*

*Omega Financial Group is a Registered Investment Adviser. This brochure is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Omega Financial Group and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Omega Financial Group unless a client service agreement is in place. *

*The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request. The Omega Financial Group is not a legal or tax advisor.*