In this article, we will distinguish between the most common types of yield and what they mean for the average investor. Yield works in concert with, and sometimes matters more to investors than, their initial investment amount. Your goals, needs, and risk aversion dictate the dance you’ll do between principal, or what you originally invest, and the income it earns. With that balance in mind, how should you view yield in relation to your investments? This article helps answer that important question.
What Is Yield?
Yield represents the income an investment generates and is usually expressed as a percentage. But be careful not to confuse yield with return. Return on investment (ROI) is typically considered profit and loss, such as capital gains. Think of yield as cash flow that happens alongside, for example, stock price appreciation. Yield exists in a handful of distinct contexts. A more precise definition becomes apparent when a qualifier is used with it—for instance, dividend yield, current yield, or yield to maturity.
Types of Yield
Let’s consider the most common types of yield investors will choose.
Dividend-paying stocks: You’ll often see stocks that pay dividends grouped on the basis of the yield they generate. We’ll get to the math later, but this is simply the amount of dividend income you can expect to receive from a stockholding, expressed as a percentage of the value of the investment. Bonds: Bonds represent one of the most common types of yield-producing investments. Bond yield, also represented as a percentage, can be fixed or variable. It functions similarly to the yield on stocks in that the percentage reflects the income you can expect to receive on the value of your investment. Rental property: Also known as the capitalization rate, the yield on rental property shows investors how much income they’ll generate on their holdings after accounting for operating expenses.
Most people will encounter one or more of these three different types of yield when investing.
How To Calculate Yield
If you’re not daunted by basic math, it’s relatively easy to determine the value of an investment’s yield.
Stocks
When you look up a stock quote, you’ll generally see the annual dividend the company pays. Divide the annual dividend by the stock price. Convert your result to a percentage and you have the dividend yield of your stock. For example, a $1 annual dividend on a $50 stock yields 2.0%. $1 / $50 = 0.02 = 2.0% If you own 100 shares of that $50 stock (a $5,000 value), you’ll receive $100 in annual income, usually paid quarterly. Without taking into account the impact of dividend reinvestment and stock price fluctuations, the company will typically pay out that dividend income in quarterly installments of $25. When all is said and done, your yield remains 2.0%.
Bonds
Things get more complicated with bonds. This is because there are different types of bond yield and different ways to calculate it, depending on factors such as how long you hold the bond, the coupon, or interest rate, and whether the interest rate is fixed or variable. The most straightforward way to calculate bond yield is to take the annual interest a bond pays and divide it by the bond’s face value. If a $10,000 bond pays $100 in annual interest, it yields 1.0%. $100 / $10,000 = 0.01 = 1.0% Another common method used to determine bond yield is called “yield to maturity” (YTM). This approach simply calculates yield on the basis of the interest payments you’ll receive (and reinvest) over the life of the bond and the return of the bond principal, or original amount invested, at maturity. Avoid confusing yield with a bond’s coupon, which is the set interest you should expect to receive twice a year. This simple math illustrates the distinction between a bond’s fixed coupon rate and its yield to maturity, or YTM. First, here’s the basic YTM formula: As an illustration using this formula, say a 10-year, $1,000 bond with a 2% coupon returns $20 annually. If you bought the bond at a discount, say at $950, the $20 yearly payments result in a yield to maturity of 2.56%. Here’s how this bond’s data works out in the formula: So, the relationship between investment value, or price, and yield functions similarly in both stocks and bonds.
Rental Property
If you own rental property, you can calculate yield by taking expenses and income into account. If you purchase a rental property for $875,000 and can rent it out for $2,700 a month on monthly expenses of $975, your yield will be 2.37%. To get to this number, you simply determine your monthly net income ($1,725), your annual net income ($20,700), and divide your annual net income by your purchase price to come up with the yield you can expect from your investment. These are some of the most common examples of yield and the numbers you’ll need to run to calculate it.
Why the Yield of an Investment Is Important
If you’re what’s called an income investor, there’s a significant chance you’re living off of—wholly or in part—the income your investments generate, or you hope to do so one day. Inside an income-focused portfolio, yield can matter as much as, if not more than, capital gains like stock-price rises. As an example, consider a portfolio of dividend-paying stocks. If you intend to pay all of your living expenses with the income this assortment of stocks generates, conduct simple math to ensure you’re earning enough or on track to do so eventually. Let’s say you require $50,000 a year ($4,167/month) to live. If you want the yield your dividend stock (or any other type of portfolio) produces to cover that, you would need a $1 million nest egg that yields 5%. You can tinker with the principal value of your nest egg as well as your needed yield number to adjust the correlation between the two, but be careful when running these estimates.
Limitations of Yield
Investors face the risk of getting into yield-driven trouble, particularly with stocks and bonds. You might have heard the phrase “chasing yield”; let’s consider two prime examples of what this means.
Stock Yield
Yield can tempt investors when a stock pays a noticeably high dividend yield. While a meaty yield shouldn’t rule out an investment, it can be a trap because rising yield generally indicates a falling stock price. Remember, with stocks, yield is partly a function of share price. For example, a $100 stock that pays a $3 annual dividend yields 3%. If that stock drops in price to $50 and the dividend stays at $3, the yield rises to 6%. While double the yield on an investment looks attractive, a stock price chopped in half might not be. If the same stock climbed to $200, the yield at a $3 dividend drops to 1.5%. Yield becomes a potential liability when the capital losses (realized or on paper) outweigh the income a stock position produces. In this case, you might be better off collecting a smaller yield from a position where the stock price—and the overall value of your investment—increases. A decrease in stock price doesn’t concern some income investors who are just focused on the income portion of their holdings. Ultimately, it comes down to your goals and how you feel about the principal value of your investments versus the amount of income they generate. Some investors are happy to forgo capital appreciation (such as stock price gains) inside an income-focused portfolio that meets their longer-term income needs and desires.
Bond Yield
Along similar lines, while a bond yield might be attractive, more aggressive investors might eschew relatively conservative bonds for stocks that focus more on the growth of invested capital. This illustrates the old adage that younger, more aggressive investors should focus on stocks with a relatively high potential for growth, while older investors closer to or in retirement should be in bonds and more conservative, income-producing stocks. But bond investors can also chase yield, too. A fundamental principle of bond investing is that market interest rates and bond prices generally move in opposite directions. So when market interest rates go up, prices of fixed-rate bonds fall. This phenomenon is known as interest-rate risk. Conversely, as yield decreases, bond prices rise. Here again, it comes down to your goals and appetite for earning income versus building capital with your investments.
