Yield is the total amount of income you earn on an investment each year as a percentage of what you spent to buy it.
A bond’s yield is the interest the bond pays divided by its price.
If you buy a 10-year 1,000 bond paying 6% and hold it until it matures, you’ll earn 60 a year for ten years – an annual yield of 6%, or the same as the interest rate.
A stock’s yield is the dividend per share divided by its current price per share.
If a company whose stock is selling for 40 a share pays an annual dividend of 0.80 a share, the stock’s yield is 2%.
However, while all bonds have a yield, only those stocks that pay dividends have yields.
In the world of stocks and bonds, higher yield may mean higher risk!
Low-rated bonds, which expose you to greater risk of default, must offer higher interest than better-rated bonds in order to sell their issues.
Those higher rates translate into higher yields per dollar of investment.
But because the issuing company may be on shaky ground, you run the risk of losing interest payments and your principal.
Similarly, some companies that have traditionally paid stock dividends may continue to do so even as their stock price slips.
That changing ratio increases the yield, which may be a sign that the company is in trouble.
On the other hand, some companies whose stock prices tend to change very little over time have traditionally paid higher dividends than others to increase investors total return.
In this case, high yield is usually not a danger sign.
It is very important to look at yield in the context of other information about a company before you make any investment decisions.
Since you calculate yield by dividing the amount you receive annually in interest or dividends by the amount you put into the investment, you can compare the rate at which different investments are contributing to the value of your portfolio.
For example, if you’re earning 500 a year on a money market mutual fund in which you’ve invested 10,000, and you earn another 500 on a savings account in which you deposited 20,000, your income is the same, but your yield is different.
The mutual fund yield is 5% (500 / 10,000 = 0.05, or 5%), but the savings account yield is just 2.5% (500 / 20,000 = 0.025, or 2.5%).
On the other hand, it can be difficult to use yield to compare different types of investments.
For example, you don’t want to compare a 2% stock yield to a 6% bond yield and conclude the stock is underperforming.
That’s because there may be a stronger potential for the stock price to increase, providing a larger total return.
Return is a measure of investment gain or loss. For example, if you buy stock for 10,000 and sell it for 12,500, your return is a 2,500 gain.
Or, if you buy stock for 10,000 and sell it for 9,500, your return is a 500 loss.
Of course, you don’t have to sell to figure return on the investments in your portfolio.
You simply subtract what you paid from their current value to get a sense of where you stand.
Long-term investors are interested in total return, which is the amount your investment increases or decreases in value, plus any income you receive.
Using the same example, if you sold a stock investment for a 2,500 gain after you’d collected 150 in dividends, your total return would be 2,650.
If you want to compare total return on two or more investments that you bought at different prices, you need to figure percent return.
You do that by dividing the total return by your purchase price.
For example, a 2,650 total return on an investment of 20,000 is 0.1325, or a 13.25% return. In contrast, a 2,650 total return on an investment of 30,000 is an 8.84% return.
So while each investment has increased your wealth by the same amount, the performance of the first is more than twice as strong as the performance of the second!