There are three principal types of return:

• Time-weighted average return (or the geometric mean or the total return);
• Dollar-weighted average return (or the internal rate of return);
• Arithmetical average return (or the arithmetical mean).*

Such returns can be remarkably different.  Consider the following data.

Here are the different returns for the data:

Time-weighted returns ignore cash inflows and outflows. They look at the return of $1.00 over the period reviewed. One dollar invested in the above fund would have grown from $1.00 to $2.00 at the end of the first year, and then would have lost 20¢ at the end of the second year, for a net gain of 80¢ on the $1.00 investment. Since the calculation is only "weighted for time" (i.e., the beginning and ending date) it is called "time weighted." It grew 80% over two years, for an annualized return of 34.2%. In other words, a compounded return of 34.2% over two years would result in an 80¢ gain.

The time-weighted return is the appropriate measure for comparing fund performance, and under security regulations it is the only approved method of calculating returns.

As illustrated above, dollar-weighted returns can be remarkably different than the other two types of returns. This is due to the fluctuating prices of risky assets. Indeed, the riskiest funds or portfolios have the greatest potential for large differences between this calculation and the other two types of return. Dollar-weighted returns depend on the timing and the amount of the cash flows in and out of the investment. In other words, they are weighted for each dollar inflow and outflow. In the above hypothetical fund, the initial investment grows from $1,000 to $2,000 in the first year (a 100% gain). One can imagine an investor liking that return, and so they add $8,000 at the beginning of Year 2, bringing their balance to $10,000. At the end of year 2, the 10% loss reduces their account by $1,000. Thus, their dollar-weighted return is 0%, since they invested a total $9,000. Dollar-weighted returns are not relevant to fund evaluation (the fund is not responsible for the timing and amount of the investments), but they do answer the question "What was my 401(k) account's rate of return?"

Dollar-weighted returns on individual options are irrelevant at best. At the fund level, comparisons should be based on time-weighted returns. But on the portfolio level, dollar-weighted returns can be quite helpful. They play a valuable role in the periodic evaluation of one's investment program through comparing one's actual return to the expected return assumed by the investment program. 

In short, the return on your account will not equal the reported returns for the funds that you are invested in because your investment occurs several times a month throughout the whole year. Therefore, to compare on a quarter to quarter basis the S & P Index or the Dow with your return is not relevant. Over a three or five year period it becomes very relevant in assessing the way your portfolio is invested.