In order for us to have a clear idea of our compound growth rate, we must first understand the Time-Weighted Rate Of Return (TWR). Remember, compound growth is simply paying yourself a percentage of your earnings and then reinvesting those earnings to generate a larger return.
In this article, we will be digging deep into the Time-Weighted Rate Of Return or TWR. We will be looking at what it is, how does it work, and why it is important for your investment portfolio. So, let’s get started.
What Is Time-Weighted Rate Of Return
In finance, there are a few metrics that have been used to measure the performance of your investment portfolio. One of those rates is the TWR which stands for “Time-Weighted Rate Of Return.” The TWR helps to measure the growth of your investment portfolio. It basically breaks up your investment portfolio into different intervals based on your deposits or withdrawals. The TWR also eliminates the distorting effects in growth rates created by the inflows and outflows of money. So it can also be used for comparing the returns of investment managers and various investment portfolios.
The importance of Time-Weighted Rate Of Return
It is hard to calculate the rate of returns from an investment portfolio where there are multiple deposits and withdrawals. This is because when you add these transactions to your investment portfolio, there will be a significant change in the investment value and performance of your portfolio. This change is due to compounding which can be witnessed in both upward and downward movements in the value of your investments.
On the other hand, multiple investments and redemptions can distort the rate of returns over a period of time. It can be difficult to know how much each transaction has contributed to the total return.
So for these reasons, we need a metric that helps us eliminate or adjust for the inflows and outflows of money. That’s where the TWR comes in. It helps us get a more accurate picture of the rate of returns for our portfolio.
How does Time-Weighted Rate Of Return work
TWR basically calculates the rate of return for your investment portfolio based on changes in cash flow. It is the calculation of the investment returns that managers generate over a specific time period that is geometrically connected or compounded. Here is the formula for calculating TWR or Time-Weighted Rate Of Return
TWR = [(1+HP1) x (1+HP2) x (1+HPn)] – 1
In this formula
- n = the number of sub-periods
- HP = (End Value – (Beginning Value + Cash Flow)) / (Beginning Value + Cash Flow)
- HPn = Return for sub-period n
Conclusion
In conclusion, the TWR or Time-Weighted Rate Of Return is a metric that helps us get a better picture of our investment portfolio returns. In other words, it helps get rid of the distortion in growth rates due to inflows and outflows of money. This makes it easier for us to analyze how well we have been performing as investors.
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