If we look back over time we can see that big market fluctuations result in consistent poor behavior. When prices are high and returns are good, money tends to flow into equity mutual funds; when prices are low, investors typically make net withdrawals of funds. The chart below looks at the flow of money into and out of equity mutual funds (the shaded histograms) on the 12-month returns of the Standard and Poor\u2019s 500 index (the solid line) over the course of two decades.<\/p>\n
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![\"\"](\"https:\/\/canary.kcprod.info/blog\/wp-content\/uploads\/2017\/08\/Market-emotion-3.png\")
<\/u><\/p>\nSource: Investment Company Institute<\/h6>\n
Some of the biggest peaks and drops coincide with some of the more emotionally charged market periods. For example, more new money was invested in equity mutual funds than ever before in the first quarter of 2000, which coincided with the top of the Internet bubble. Then in the fourth quarter of 2002, which turned out to be the market bottom after a sharp decline in stock prices, investors pulled large amounts of money out of equity mutual funds. Fast forward to the third quarter of 2008, during the worst of the recent financial crises in recent history, and investors redeemed unprecedented amounts of equity mutual funds. The market is unpredictable, so we\u2019ll always have big swings. And while some people might get lucky timing the market, it\u2019s just that — luck.<\/p>\n
Money vs. Time<\/strong><\/h3>\nWe see this behavior among some of our own clients, who make occasional deposits to try and capitalize on upward market swings. Again, this is human nature, so another way to make the argument and help change that behavior is to look at the money-weighted return of frequent depositors versus their time-weighted return.<\/p>\n
A money-weighted return takes into consideration the timing of your investments, and the return is calculated based on when you invest add-on deposits or make a withdrawal. In contrast, time-weighted returns assigns each period\u2019s return the same weight, regardless of how much money was invested or taken out. It\u2019s effectively a measure of your compounded return (or the product of all your daily returns), and does not <\/em>take into consideration when you make your add on investments.<\/p>\nFor example, two investors have a portfolio valued at $100,000. The first investor contributes an additional $25,000 on August 15th, while second investor withdraws $25,000 on the same date, and then the market subsequently has a downturn. Both investors would have exactly the same time-weighted return, even though the first made a large contribution right before a downturn, and the second made a large withdrawal. Alternatively, the first investor would have a significantly lower money-weighted return because he made a large contribution prior to the downturn. The money-weighted return for the second investor would be significantly higher<\/em> because she made a large withdrawal prior to the period of poorer market performance. Thus, time-weighted returns are the superior way to evaluate your investment manager because he or she doesn’t have control over your cash flows, and money weighted return is the better way to test your ability to time the market.<\/p>\nThe chart below compares the money weighted return of our clients who made at least three add on deposits on a non-scheduled basis with their time weighted return since inception.<\/p>\n
![\"\"](\"https:\/\/canary.kcprod.info/blog\/wp-content\/uploads\/2017\/08\/Screen-Shot-2017-08-30-at-10.57.30-AM-640x400.png\")
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Source: Wealthfront<\/h6>\n
For example, two investors have a portfolio valued at $100,000. The first investor contributes an additional $25,000 on August 15th, while second investor withdraws $25,000 on the same date, and then the market subsequently has a downturn. Both investors would have exactly the same time-weighted return, even though the first made a large contribution right before a downturn, and the second made a large withdrawal. Alternatively, the first investor would have a significantly lower money-weighted return because he made a large contribution prior to the downturn. The money-weighted return for the second investor would be significantly higher<\/em> because she made a large withdrawal prior to the period of poorer market performance. Thus, time-weighted returns are the superior way to evaluate your investment manager because he or she doesn’t have control over your cash flows, and money weighted return is the better way to test your ability to time the market.<\/p>\n The chart below compares the money weighted return of our clients who made at least three add on deposits on a non-scheduled basis with their time weighted return since inception.<\/p>\n<\/p>\nSource: Wealthfront<\/h6>\n