Time-weighted vs. dollar-weighted returns.

Do you get statements from your mutual-fund company or brokerage firm telling you how your account has performed? It's important to understand how those returns are calculated.

Sometimes, the results shown are time-weighted. A time-weighted return simply reflects how much your money would have grown if you had opened the account at the beginning of the period and didn't subsequently add or remove any money. Let's say you invested $10,000 five years ago and your cumulative time-weighted return was 25%. If you made no account contributions or withdrawals, your account would grow to $12,500 by the end of the five years.

This is usually a reasonable reflection of your portfolio's performance--but not always. To understand why, it's helpful to consider the difference between time-weighted returns and the alternative way of calculating performance, known as dollar-weighted returns. A dollar-weighted return takes into consideration the money you subsequently added to the account or withdrew, and at what price those trades occurred. Because of these contributions or withdrawals, your dollar-weighted return could be significantly different from your time-weighted return.

Imagine you opened an account five years ago and the market was still at the same level five years later, so your time-weighted return was 0%. During the intervening five years, however, the market fell steeply and then recovered. If you added a large sum to your account during the market decline, you likely made money-and your dollar-weighted return would be greater than your 0% time-weighted return. Conversely, if the market rose before falling back and you invested additional money when market prices were high, your dollar-weighted return would be less than your 0% time-weighted return.

What if you haven't made a lot of withdrawals or deposits? Your dollar-weighted return may be quite similar to your time-weighted return.

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