A portfolio can outperform its benchmark while its investor earns nothing. Before you explain time-weighted or dollar-weighted return, identify whose return you are measuring and what happened to the money.
When you review a customer's statement, a larger balance does not automatically mean successful investing. Total return includes investment income and capital appreciation or depreciation over the measurement period. Capital appreciation means an increase in investment value; depreciation means a decrease. Interest and dividends contribute to performance even when prices stay unchanged.
Price return measures only the change in price. You use total return when the customer asks how much the investment earned overall. A price decline can coexist with a positive total return if income exceeds the decline.
External contributions are not investment returns. A customer's deposit increases account value without creating a profit. Withdrawals reduce the account without necessarily creating a loss. Buying or selling securities within the account moves existing assets and is not an external contribution or withdrawal.
Common mistakes
- Counting deposits as profit. An account rising from $5,000 to $7,000 immediately after a $2,000 deposit has earned 0%.
- Counting dividends twice. If $10,000 becomes $10,700 including reinvested dividends, total return is 7%; adding another $200 distribution would incorrectly produce 9%.
- Adding successive returns. A 25% gain followed by a 20% loss gives 1.25 × 0.80 − 1 = 0%, not 5%.
Bottom line
- Total return includes income and price changes, excludes external contributions, and counts reinvested distributions once.
- Time-weighted return links subperiod growth factors; dollar-weighted return measures the investor's dated cash flows through IRR.
- Annualized return converts cumulative performance into a compound yearly rate.
- Sharpe uses standard deviation, Treynor uses beta, and Jensen's alpha compares actual return with CAPM's prediction.
Exam shortcut
Identify the question's target before calculating: manager, investor, yearly growth, spending power, or annual income. Circle contribution dates. For IRR, draw the timeline from the investor's perspective and enter contributions as negatives. For successive returns, convert percentages into growth factors immediately. A 10% loss becomes 0.90, not negative 0.10. When Sharpe and Treynor appear together, compute excess return once, then inspect the denominator.
The full lesson (about 3,225 words, 22 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- C18
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