Why is the money-weighted rate of return often not recommended?

The money-weighted rate of return, also known as the internal rate of return (IRR), is influenced significantly by the size and timing of cash flows into and out of an investment portfolio. This characteristic can make it less useful for assessing investment performance because if cash flows occur at different times and amounts, they can distort the perceived success of the investment.

For instance, if a large deposit is made just before a market run-up, the money-weighted rate may present an inflated value of returns, reflecting the strong performance based on when the cash was invested. Conversely, large withdrawals during a downturn can also skew results negatively, making the performance seem worse than it actually was. These fluctuations mean that the money-weighted return can vary dramatically based on the investor's timing, rather than the underlying performance of the portfolio itself.

This sensitivity to cash flows makes the money-weighted rate of return less reliable for comparing performance across different investments or portfolios, particularly when those portfolios have diverse cash flow patterns. Investors typically prefer metrics that reflect pure performance without the influence of cash flows, such as the time-weighted rate of return, which measures performance over time regardless of the timing of cash flows.