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D.30.1 Investment Performance Measures

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1 A. Professional Conduct and Regulation

A.1 Code of Ethics and Standards of Conduct A.1.1 The Six Ethical Principles A.2 Procedural Rules and Discipline A.2.1 Fitness Standards for Candidates A.3 Financial Institutions Overview A.3.1 Broker-Dealers vs. RIAs A.4 SEC and Securities Regulation A.4.1 FINRA and Broker-Dealer Regulation A.4.2 State Securities Regulation A.5 Consumer Protection Laws A.5.1 Privacy and Confidentiality Requirements A.6 Fiduciary Duty and Application

2 B. General Principles of Financial Planning

B.7 The Financial Planning Process B.7.1 Establishing the Client Relationship B.7.2 Gathering Client Data and Goals B.8 Personal Financial Statements B.8.1 Key Financial Ratios B.9 Cash Flow Management B.9.1 Emergency Fund Planning B.10 Debt Management Strategies B.10.1 Mortgage and Home Financing B.11 Economic Concepts B.11.1 Planning for Inflation B.12 Time Value of Money Concepts B.12.1 TVM Calculations and Applications B.12.2 Loan Amortization B.13 Education Needs Analysis B.14 Education Savings Vehicles B.14.1 529 Plans In-Depth B.15 Education Funding Strategies B.16 Gift/Income Tax Strategies

3 C. Risk Management and Insurance Planning

C.17 Principles of Risk and Insurance C.17.1 Risk Management Process C.18 Analysis of Risk Exposures C.19 Health Insurance Fundamentals C.19.1 Types of Health Insurance Plans C.20 Disability Income Insurance C.20.1 Disability Policy Features C.21 Long-Term Care Insurance C.22 Annuities Overview C.22.1 Fixed vs. Variable Annuities C.23 Life Insurance Fundamentals C.23.1 Types of Life Insurance C.24 Business Owner Insurance Solutions C.25 Insurance Needs Analysis C.26 Insurance Policy and Company Selection

4 D. Investment Planning

D.27 Equity Securities D.27.1 Fixed Income Securities D.27.2 Mutual Funds and ETFs D.27.3 Taxation of Investment Vehicles D.28 Systematic Risk D.28.1 Unsystematic Risk D.29 Economic and Market Cycles D.30 Measures of Risk and Return D.30.1 Investment Performance Measures D.31 Asset Allocation Strategies D.31.1 Portfolio Diversification D.32 Bond and Stock Valuation D.32.1 Stock Valuation Models D.33 Investment Policy Statement D.33.1 Modern Portfolio Theory D.34 Active vs. Passive Investing D.34.1 Common Investment Strategies D.35 Alternative Investments D.35.1 Options and Derivatives

5 E. Tax Planning

E.36 Income Tax Fundamentals E.36.1 Filing Status and Tax Brackets E.37 Types of Income E.37.1 Deductions and Credits E.37.2 Capital Gains and Losses E.38 Business Entity Taxation E.38.1 Self-Employment Tax E.39 Taxation of Trusts and Estates E.40 Tax Reduction Strategies E.40.1 Retirement Account Tax Strategies E.41 Property Transactions E.41.1 Basis Rules for Acquired Property E.42 AMT and NIIT E.42.1 Special Tax Situations E.43 Charitable Giving Strategies

6 F. Retirement Savings and Income Planning

F.44 Retirement Needs Analysis F.44.1 Sources of Retirement Income F.45 Social Security Benefits F.45.1 Social Security Claiming Strategies F.45.2 Medicare Planning F.46 Eldercare and Special Needs Planning F.47 Qualified Plan Overview F.47.1 Defined Benefit Pension Plans F.47.2 Defined Contribution Plans F.48 Eligibility and Vesting F.48.1 Coverage and Discrimination Testing F.48.2 Contribution and Benefit Limits F.48.3 401(k) Plan Features F.49 Non-Qualified Deferred Compensation F.49.1 Executive Compensation Plans F.50 Retirement Plan Selection for Businesses F.50.1 Individual Retirement Accounts F.51 Distribution Rules F.51.1 Required Minimum Distributions F.52 Retirement Income Strategies F.52.1 Tax-Efficient Withdrawal Strategies F.53 Business Succession Planning

7 G. Estate Planning

G.54 Property Titling and Beneficiary Designations G.54.1 Beneficiary Designations G.55 Strategies to Transfer Property G.55.1 Lifetime Gifting Strategies G.56 Wills and Estate Documents G.56.1 Powers of Attorney G.56.2 Advance Directives and Healthcare Documents G.57 Federal Gift Tax G.57.1 Federal Estate Tax G.57.2 Generation-Skipping Transfer Tax G.58 Sources for Estate Liquidity G.58.1 Life Insurance for Estate Liquidity G.59 Trust Fundamentals G.59.1 Revocable Living Trusts G.59.2 Irrevocable Trusts G.59.3 Trust Income Taxation G.60 Marital Deduction Planning G.60.1 QTIP Trusts G.60.2 Portability of Estate Tax Exemption G.61 Intra-family and Business Transfer Techniques G.61.1 Family Limited Partnerships G.61.2 GRATs and IDGTs G.62 Postmortem Estate Planning Techniques G.62.1 Disclaimer Planning G.62.2 Estate Tax Elections G.63 Planning for Divorce and Unmarried Couples G.63.1 Estate Planning for Unmarried Couples G.63.2 Planning for Blended Families G.64 Planning for Special Needs and Circumstances G.64.1 Special Needs Trusts G.64.2 ABLE Accounts

8 H. Psychology of Financial Planning

H.65 Client and Planner Attitudes, Values, Biases H.65.1 Money Scripts and Money Attitudes H.65.2 Planner Self-Awareness H.66 Behavioral Finance H.66.1 Cognitive Biases H.66.2 Emotional Biases H.66.3 Heuristics and Mental Accounting H.67 Sources of Money Conflict H.67.1 Couples and Money Conflict H.67.2 Family and Intergenerational Money Conflict H.68 Principles of Counseling H.68.1 Therapeutic Techniques in Financial Planning H.68.2 Professional Boundaries and Referrals H.69 General Principles of Effective Communication H.69.1 Listening and Questioning Skills H.69.2 Managing Difficult Conversations H.69.3 Non-Verbal Communication H.70 Crisis Events with Severe Consequences H.70.1 Death and Divorce H.70.2 Job Loss and Health Crisis H.70.3 Sudden Wealth and Sudden Loss H.70.4 Natural Disasters and Traumatic Events

D.30.1 Investment Performance Measures

Key Takeaways Explain This Topic AI

Holding period return (HPR) measures total return over an investment period regardless of time held

Geometric mean is a time-weighted compounded return; arithmetic mean is a simple average (use geometric for multi-period returns)

Time-weighted return (TWR) eliminates cash flow effects--use for evaluating MANAGER performance

Dollar-weighted return (IRR) includes cash flow timing--use for evaluating INVESTOR results

Sharpe ratio uses standard deviation (total risk); Treynor ratio uses beta (systematic risk); Jensen's alpha shows absolute outperformance

Last updated: January 2026

Investment Performance Measures

Performance measurement is heavily tested on the CFP exam. Understanding when to use each measure--and how to calculate them--is essential for evaluating investments and managers.

Holding Period Return (HPR)

Holding period return measures the total return earned on an investment during the period it was held. HPR does NOT consider the length of the holding period--a 10% return is a 10% HPR whether earned in one month or five years.

  • Formula
  • HPR = (Ending Value - Beginning Value + Income) / Beginning Value

Or equivalently:

  • HPR = (Selling Price - Purchase Price +/- Cash Flows) / Initial Investment
  • Simple Example

An investor buys a stock for $50 and sells it for $55 after receiving $2 in dividends.

  • HPR = ($55 - $50 + $2) / $50 = $7 / $50 = 14%
  • Margin Transaction Example

This is commonly tested. An investor must calculate the return on their actual equity (out-of-pocket investment), not the total position value.

Example: Joe buys 100 shares at $20 with 60% initial margin. After one year, he pays 10% margin interest and sells at $30. What is the HPR?

  • Step 1: Calculate out-of-pocket investment
  • Total purchase: $20 x 100 = $2,000
  • Equity invested (60%): $2,000 x 0.60 = $1,200
  • Amount borrowed (40%): $2,000 x 0.40 = $800
  • Step 2: Calculate total gain and cash flows
  • Sale proceeds: $30 x 100 = $3,000
  • Total purchase price: $2,000
  • Gain on position: $3,000 - $2,000 = $1,000
  • Interest paid: $800 x 10% = $80
  • Step 3: Calculate HPR
  • HPR = ($1,000 - $80) / $1,200 = $920 / $1,200 = 76.67%
  • Multi-Period HPR

When given periodic returns, compound them:

  • HPR = [(1 + r1) x (1 + r2) x ... x (1 + rn)] - 1
  • Example: Monthly returns of 2%, 3.5%, and -1.5%
  • HPR = (1.02 x 1.035 x 0.985) - 1 = 1.0399 - 1 = 3.99%
  • Arithmetic vs. Geometric Mean
  • Arithmetic Mean

Arithmetic mean is a simple average of returns. Add the returns and divide by the number of periods.

  • Arithmetic Mean = (R1 + R2 + ... + Rn) / n
  • Example: Returns of 10%, 15%, and -5%
  • Arithmetic Mean = (10% + 15% + (-5%)) / 3 = 20% / 3 = 6.67%
  • Geometric Mean

Geometric mean is a time-weighted, compounded return. It accounts for the compounding effect.

  • Geometric Mean = [(1 + R1) x (1 + R2) x ... x (1 + Rn)]^(1/n) - 1
  • Example: Returns of 10%, 15%, and -5%

On calculator:

  • PV = -1 (initial investment of $1)
  • FV = (1.10)(1.15)(0.95) = 1.2017
  • N = 3
  • I/Y = ? = 6.30%
  • Key Differences
  • Characteristic Arithmetic Mean Geometric Mean
  • What it measures Simple average Compounded growth rate
  • Higher/Lower Always higher (or equal) Always lower (or equal)
  • Volatility effect Ignores volatility Penalizes volatility
  • Best for Expected future returns Historical performance

Important: When there is ANY volatility in returns, the geometric mean will ALWAYS be lower than the arithmetic mean. The more volatile the returns, the greater the difference.

Example of Volatility Impact:

  • Year 1: +50%, Year 2: -50%
  • Arithmetic Mean: (50% + (-50%)) / 2 = 0%
  • Geometric Mean: [(1.50)(0.50)]^0.5 - 1 = [0.75]^0.5 - 1 = -13.4%

Despite an arithmetic average of 0%, the investor actually lost 25% ($1 to $1.50 to $0.75).

Time-Weighted Return (TWR)

Time-weighted return measures the compound rate of growth of $1 invested, eliminating the effect of cash flow timing. It treats each sub-period equally, regardless of how much money was invested.

  • When to Use TWR
  • Evaluating MANAGER performance - The manager does not control when clients add/withdraw money
  • Comparing fund managers - Fair comparison regardless of fund flows
  • Mutual fund reporting - Funds report on a time-weighted basis
  • How TWR Works

TWR breaks the investment period into sub-periods at each cash flow, calculates the return for each sub-period, then compounds them.

Example Calculation

An investor buys 1 share of stock for $50. After one year, the stock is worth $65 and pays a $4 dividend. The investor buys another share at $65. After another year, each share is worth $75.

  • Period 1 (before second purchase): HPR1 = ($65 + $4 - $50) / $50 = $19 / $50 = 38%
  • Period 2 (after second purchase): HPR2 = ($75 - $65) / $65 = $10 / $65 = 15.38%
  • Time-Weighted Return (compounded): TWR = [(1 + 0.38)(1 + 0.1538)]^(1/2) - 1 = [1.593]^0.5 - 1 = 26.2% annually

Notice: TWR ignores that the investor had more money invested in Period 2.

Dollar-Weighted Return (Money-Weighted Return/IRR)

Dollar-weighted return is the internal rate of return (IRR) of all cash flows. It considers when money was added or withdrawn, reflecting the investor's actual experience.

When to Use Dollar-Weighted Return

Evaluating INVESTOR results - What did the investor actually earn?

When timing matters - Cash flow timing significantly impacts return

Personal performance assessment - How did MY investment decisions work out?

How Dollar-Weighted Return Works

It is the discount rate that makes the present value of all cash inflows equal to the present value of all cash outflows--the IRR.

Example Calculation

Same scenario as above: Buy 1 share at $50, receive $4 dividend, buy another share at $65, sell both shares at $75.

Cash Flow Timeline:

  • Time 0: -$50 (initial purchase)
  • Time 1: $4 - $65 = -$61 (dividend received, second share purchased)
  • Time 2: $150 (sell 2 shares at $75 each)
  • Using IRR function on calculator: CF0 = -50
  • CF1 = -61
  • CF2 = 150
  • IRR = 22.63%
  • TWR vs. Dollar-Weighted Return Comparison
  • Characteristic Time-Weighted Return Dollar-Weighted Return
  • Other names TWR, geometric return DWR, money-weighted, IRR
  • Cash flow timing Eliminated Included
  • Evaluates Manager performance Investor experience
  • Used by Mutual funds, GIPS Individual investors
  • When equal When no cash flows Never equal otherwise
  • When They Differ Significantly
  • Large cash flows relative to portfolio size
  • High performance volatility during the period
  • If investor adds money before good performance: DWR > TWR
  • If investor adds money before poor performance: DWR < TWR

CFP Exam Tip: Mutual funds report on a TIME-WEIGHTED basis. This allows fair comparison between funds, regardless of investor cash flow timing.

Risk-Adjusted Performance Measures

These measures evaluate return relative to the risk taken. Higher values indicate better risk-adjusted performance.

Sharpe Ratio

The Sharpe ratio measures excess return per unit of total risk (standard deviation).

Formula: Sharpe Ratio = (Rp - Rf) / Standard Deviation p

Where:

  • Rp = Portfolio return
  • Rf = Risk-free rate
  • Standard Deviation p = Portfolio standard deviation

Key Points:

  • Uses standard deviation (total risk)
  • Appropriate for non-diversified portfolios
  • Higher Sharpe ratio = better performance
  • Relative measure - must compare to other funds
  • Example: Portfolio return = 12%, Risk-free rate = 3%, Standard deviation = 18%
  • Sharpe = (12% - 3%) / 18% = 9% / 18% = 0.50

For every 1% of total risk, the portfolio earned 0.50% of excess return.

Treynor Ratio

The Treynor ratio measures excess return per unit of systematic risk (beta).

Formula: Treynor Ratio = (Rp - Rf) / Beta p

Where:

  • Rp = Portfolio return
  • Rf = Risk-free rate
  • Beta p = Portfolio beta

Key Points:

  • Uses beta (systematic risk only)
  • Appropriate for well-diversified portfolios
  • Higher Treynor ratio = better performance
  • Relative measure - must compare to other funds
  • Example: Portfolio return = 12%, Risk-free rate = 3%, Beta = 1.5
  • Treynor = (12% - 3%) / 1.5 = 9% / 1.5 = 6.0

For every unit of systematic risk, the portfolio earned 6% excess return.

Jensen's Alpha

Jensen's alpha measures the portfolio's excess return above what CAPM predicts. It shows absolute outperformance.

Formula: Alpha = Rp - [Rf + Beta p(Rm - Rf)]

Where:

  • Rp = Portfolio return
  • Rf = Risk-free rate
  • Beta p = Portfolio beta
  • Rm = Market return

Key Points:

  • Absolute measure - positive alpha is good by itself
  • Measures manager skill in generating excess returns
  • Positive alpha = outperformed risk-adjusted expectations
  • Negative alpha = underperformed risk-adjusted expectations
  • Example: Portfolio return = 15%, Risk-free rate = 3%, Beta = 2.0, Market return = 8%
  • Expected return = 3% + 2.0(8% - 3%) = 3% + 10% = 13%
  • Alpha = 15% - 13% = +2%

The manager outperformed by 2% on a risk-adjusted basis.

Information Ratio

The information ratio measures excess return relative to a benchmark, per unit of tracking error.

Formula: Information Ratio = (Rp - RB) / Tracking Error

Where:

  • Rp = Portfolio return
  • RB = Benchmark return
  • Tracking Error = Standard deviation of excess return

Key Points:

  • Measures consistency of outperformance relative to benchmark
  • Higher information ratio = more consistent outperformance
  • Relative measure - compare to other actively managed funds
  • Choosing the Right Performance Measure
  • Situation Measure Reason
  • Non-diversified portfolio Sharpe Ratio Uses total risk (standard deviation)
  • Well-diversified portfolio Treynor Ratio Uses systematic risk only (beta)
  • R-squared < 0.70 Sharpe Ratio Beta is unreliable
  • R-squared > 0.70 Treynor Ratio Beta is reliable
  • Evaluate if manager beat expectations Jensen's Alpha Absolute measure
  • Compare fund managers Sharpe or Treynor Relative measures
  • Evaluate investor's actual results Dollar-Weighted Return Includes cash flow timing
  • Evaluate manager skill Time-Weighted Return Excludes cash flow timing
  • Summary Table of Performance Measures
  • Measure Formula Risk Used Type Best For
  • Sharpe (Rp - Rf) / Std Dev Total (std dev) Relative Non-diversified
  • Treynor (Rp - Rf) / Beta Systematic (beta) Relative Diversified
  • Jensen's Alpha Rp - [Rf + Beta(Rm - Rf)] Systematic Absolute Manager skill
  • Information (Rp - RB) / Tracking Error Active Relative Active management

CFP Exam Tip: If the exam does not give you R-squared to determine if beta is reliable, use Sharpe ratio as the default. When in doubt, total risk (standard deviation) is the safer choice.