One of the primary concepts in investing is yield. An investment’s yield refers to the income return on an asset from interest or dividends. Yield is typically expressed as an annual percentage rate and takes into account the investment’s cost, current market value or face value.
Take this example. Say you tell a friend that you made $1,000 on an investment. Good news, right? But, just how good will depend on the yield.
If you invested, say, $2,000 and now have $3,000, that’s a pretty impressive yield as a percentage of your investment. Now, if you invested $1 million and earned that same $1,000, the news isn’t quite as exciting.
Not only is yield an important component of investing overall, but it’s also a pillar of a favorite strategy of mine – income investing. As a refresher, income investing prioritizes generating cash flow from your assets. The income you receive from stock dividends, bond interest or disbursements can be reinvested, during your working years to help create an accelerated rate of growth for your portfolio. Then, once retirement time rolls around, the cash flow from your investments is redirected to give you a “paycheck” to help fund your spending needs.
Let’s talk about the different types of investment yield. The first is yield from dividends paid by stocks and ETFs (called dividend yield), and the second is yield from interest on bonds.
The dividend yield is given as a percentage, rather than a pure dollar amount. (Conversely, dividend rates are expressed in dollars and cents.) If we think about it, this calculation provides more information about just how good a particular yield is.
It’s better to receive $3 in dividends on a $50 stock than $5 in dividends on a $100 stock. If an investor purchased two of the $50 shares, they would receive $6 in dividends, besting the return from the $100 stock. So, the dividend yield expressed as a percentage tells you the most efficient way to earn a return. When a company pays out dividends at a higher percentage of its share price, shareholders can garner a greater return on their investments.
It’s easy to confuse “yield” and “total return” when thinking about what you have earned from stocks. Remember, the cash you are paid by a company whose stock you own is the “dividend yield.” This income is analyzed over a specific time period and then annualized, with the assumption it will continue to be offered at the same rate. In this regard, yield is forward-looking.
The “total return” is your profit or loss on your investment. This figure expresses what you have earned on an investment in the past, and includes interest, dividends, and capital gain (such as an increase in the share price). In other words, a return is backward-looking.
When it comes to bonds, there are three ways to measure return: as a percentage of what you invested (cost yield), as a percentage of the current value of the bonds (current yield), or as a more complex calculation of what your return on the bond will be if you hold it until it matures (yield to maturity).
So, when thinking about your investments, remember to differentiate between yield and total return. In today’s healthy bull market, perhaps this doesn’t feel as important because the economy (and our portfolios) seem to be thriving. But if there is a dip in the market and your total return takes a tumble, the distinction between these two terms will be all the more critical because your dividends should still be there for you.
This point is of particular importance if you’re retired or within five years of retiring. If we forget the difference between yield and total return, we risk our emotions getting stirred when the market slips. And, with a focus on yield, you keep your eye on how you would like to pay yourself in retirement.
Sounds a lot like income investing to me.