What is it about?
Investors often want a simple answer to a seemingly equally simple question: how is my investment doing? But what sounds so simple can sometimes be quite complicated.
In the following, we will take a closer look at two concepts for calculating returns.
The simple yield calculation as status quo
Intuitively, most investors would use two variables to calculate their return: net investment amount (i.e., deposits minus withdrawals) and profit. In the simple yield calculation, which Ginmon also used so far, the profit is divided by the net investment amount.
The simple return is therefore not only comparatively uncomplicated to calculate, but also very easy to understand.
Simple return = profit / net investment amount
However, there are also some arguments against this calculation method. This is because the simple rate of return ignores the impact that cash flows such as inflows and outflows have. Thus, deposits dilute the return, since the net investment amount jumps, but the profit in euros remains constant for the time being.
Consequently, the return on investment is presented as too low. In the case of payouts, the opposite is true – if you pay out a higher sum, it looks as if a small net investment sum has suddenly brought in the same profit. Thus, the yield increases and is depicted as too high. We will show you what this looks like in a practical example below.
The money-weighted return takes into account the effect of cash inflows and outflows
The money-weighted or value-weighted return, in contrast to the simple return, takes into account the timing and amount of all inflows and outflows and counteracts the dilution or compounding of returns.
For example, if one pays in a large amount, this does not reduce the return as in the simple return calculation. The formula takes into account that this deposit has only just taken place and therefore has not yet had time to generate any return at all.
Especially for Ginmon investors who invest regularly with the help of a savings plan, the return has been reported significantly too low so far.
The only disadvantage of this method of calculation is that the formula is relatively complicated and therefore the displayed return is not easy for the investor to understand.
The difference in yield of the calculation methods in practice
What would the difference in calculation methods look like on an example portfolio?
Imagine you invest 10,000 euros today and in one year it has become 11,000 euros – that corresponds to a return of 10%. If you are now invested for another year and your portfolio has grown by another 10%, then your portfolio has generated a return of 21%.
Since there were no deposits or withdrawals within this period, both the simple and the money-weighted calculation methods yield the same result.
Case 1: Additional deposits
But what does it mean if you decide to invest another 10,000 euros in your portfolio after one year and it also increases in value by +10% in the second year?
According to the simple return calculation, your profit is now 15.5%. That would mean your investment performed worse simply because you invested extra money after one year.
Of course, this is a fallacy and the simple return calculation proves to be inappropriate in this case, as the deposit has diluted the return. The money-weighted return, on the other hand, achieves the same result as before, namely 21%.
Case 2: Payouts
How do the returns behave now if you decide to withdraw 5,000 euros from your portfolio after one year and your portfolio increases in value by +10% in both years?
According to the simple return calculation, your profit is now a whopping 32%. That would mean your investment performed fantastically merely because you withdrew some of your money after one year.
In extreme cases, you could even withdraw your entire deposits and remain invested only with the profit. In that case, the return would be infinite according to the simple calculation methodology.
After all, you would have made a profit with virtually no capital investment. This is, of course, wrong. The money-weighted return, on the other hand, again correctly represents a 21% gain.
Thus, it can be seen that the simple return calculation is susceptible to inflows and outflows, while the money-weighted return consistently shows the same correct result and thus reflects a real estimate of the performance.
However, this is at the expense of comprehensibility. This is because the money-weighted return is difficult for investors to calculate and understand.
Conclusion
Both methods of calculating the rate of return are valid and acceptable, but they have their own peculiarities, which must be taken into account when interpreting them. If no intermediate deposits and withdrawals are made, both methods yield the same return.
However, if capital inflows or outflows occur in the meantime, as is the case regularly with savings plans, for example, the money-weighted calculation provides a more correct overall picture of the return achieved.
