Among the many different ways of measuring the returns of a portfolio or investment, two common methods stand out: IRR and ROI. These represent two distinct approaches—money-weighted and time-weighted returns, respectively.
Although these two methods of calculating returns differ significantly, they can also complement each other, as we'll see in this text. So, it's not always necessarily a matter of choosing one over the other.
1. Time Weighted Returns
Measuring returns with metrics such as ROI can be considered time-weighted. ROI provides insight into the compounding of returns over a specific time horizon. It is typically calculated by averaging the returns of an investment—often using a geometric average, as discussed previously.
This type of return does not account for the timing of investments and their size, as it evaluates returns in relative terms. It assigns equal weight to each period and ignores both cash inflows/outflows and the time value of money.
Time-weighted returns are often used to independently evaluate the performance of an investment. For example, when comparing two mutual funds, we would use the time-weighted return to remove the effects of capital inflows and outflows from each fund’s NAV, thereby focusing solely on the fund manager’s performance. Time-weighted returns offer a clear and objective view of an investment's profitability.
2. Money Weighted Return
Measuring with IRR, on the other hand, represents the money-weighted rate of return. IRR defined as the discount rate that sets the net present value (NPV) of all cash flows to zero. In other words, it is the rate at which the investment breaks even in present-value terms.
Unlike ROI, IRR accounts for the size and timing of each cash flow, and it incorporates the time value of money. It assumes that all payouts and dividends are reinvested at the same rate (the IRR), whereas ROI makes no such assumption.
IRR is especially useful for evaluating investments where the investor has control over cash inflows and outflows—such as private equity, real estate, or personal portfolios. It reflects the actual return experienced by the investor, taking into account when and how much money was invested or withdrawn.
3. Which one to choose and when
When choosing between the two types of return metrics, several factors must be considered—some of which we’ve already discussed. To make things easier, I’ve compiled the key differences into a simple table—a quick, scannable cheat sheet for reference.
| Feature | Time-Weighted Return (ROI) | Money-Weighted Return (IRR) |
|---|---|---|
| Difficulty | Easier to compute | Harder to compute |
| Weights | Does not weight cash flows | Weights cash flows based on size and timing |
| Reinvestment | Does not assume reinvestment of dividends or cash flows by default | Assumes all cash flows are reinvested at the IRR |
| Use Case | Ideal for comparing fund managers independent of investor cash flows | Best for evaluating performance where the investor controls cash flows (e.g., private equity) |
| Time Value of Money | Does not consider the time value of money (TVM) | Fully accounts for TVM |
| Investment Horizon | Better suited for shorter-term comparisons | More appropriate for longer-term investments |
As mentioned at the beginning, choosing between ROI and IRR is not always a binary decision. There are many cases where both time-weighted and money-weighted returns are used together.
In fact, a common approach among investors is to first apply the time-weighted return to screen a large number of investments quickly. This method is fast, simple, and requires less detailed data. Once a shortlist of promising investments is identified, they then perform a more detailed analysis using IRR, which provides a more comprehensive, nuanced view of performance—especially in scenarios involving complex cash flows or longer investment horizons.
In summary, ROI offers speed and simplicity, while IRR delivers depth and accuracy. Together, they can provide a balanced and effective evaluation strategy.