How dollar-weighted investment returns work
The key consideration in calculating dollar-weighted investment returns is that deposits and withdrawals from your account affect how much money you have invested at any given time. As an extreme example, say you had $1,000 invested in a fund on January 1, you withdraw $1,000 on February 1, and then redeposit $1,000 on December 1, with the end-of-year balance growing to $1,010. Your account has gone up by 1%, but all of those gains came in the two months during which you had money in the account. Using simple interest calculations, if you earned 1% in two months, then over the full 12-month period, your dollar-weighted rate of return was 6%.
Dollar weighting can affect returns in either direction. Take the same example as above, except instead of withdrawing $1,000 on February 1, you deposit $12,000 and then withdraw the $12,000 on December 1. Your account rose by the same 1%, but you had far more money invested during most of the year -- an average of $11,000. The dollar-weighted rate of return would be just 0.09%.
