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Importance of Return
What are the types of yield/return
Returns can be classified according to the type of security.
Yield on Stocks
This is based on the type of security.
For investments in stock, two types of returns are popularly known.
- Cost yield: This is gotten when the return is calculated based on the purchase price.
Cost Yield = (Price Increase + Dividends Paid) / Purchase Price
- Current yield: To calculate the return here, you use the current market price.
Current Yield = (Price Increase + Dividend Paid) / Current Price
When a company’s stock price increases, the current return decreases because of the inverse relationship between yield and stock price.
Understanding Dividend stock and how to invest is a resource for you to read.
Yield on Bonds
This is another type of return according to security.
There are bonds that pay annual interest. Their calculation is according to the nominal yield.
Nominal Yield = (Annual Interest Earned / Face Value of Bond)
For example, if there is a bond with a face value of $1,000 and maturity of one year and pays 5% annual interest. The return is $50 / $1,000 = 0.05 or 5%.
However, it is important to note that there are bonds with floating interest rates. Their returns change and are not steady over the life of the bond.
Mutual fund yield
This represents the net income return of a mutual fund.
You calculate it by dividing the annual income paid by the value of a mutual fund’s shares.
It includes the income received through dividends and interest earned during the given year.
Since mutual fund valuation changes based on the daily net asset value, the mutual fund returns also vary with the fund’s daily market value.
How to Calculate Yield?
It measures the cash flow an investor receives on the amount invested.
Generally, yield meaning = dividends or interest received in a set period of time / amount originally invested or current price.
For a bond, for example, if you invest $900 in a $1,000 bond that pays a 5% coupon rate, your interest income would be ($1,000 x 5%) = $50. The current yield will be ($50)/($900) = 5.56%.
High return either in stocks or bonds can be the result of a falling market value of the security.
For a stock, there are two kinds of yields: the yield on cost, and current yield.
Yield on Cost = Div/Purchase Price and Current Yield = Div/Current Price
If an investor puts $100 into a stock that paid $1 as an annual dividend. The yield on cost is $1/$100 = 0.01 = 1%.
If the investment made $10 during the year, and its current yield is $1/$110 = 0.009 = 0.91%.
From the examples, we can conclude that if the stock price increases and the dividend remain the same, the current yield will be lower than when the stock was originally bought. This is because yields have an inverse relationship with the stock price.
How to evaluate yield
Yield is one part of the total return of holding a security.
A higher return allows the owner to regain his investment amount sooner, and so reduces risk. On the other hand, this high return may have been a result of higher risk that has made the market value to fall.
Fears of high inflation in the future mean that investors ask for a high return on investment today.
The relationship between yields and maturity is described by the yield curve.
The more the risk, the higher the return since investors need a form of compensation for the risk.
Yield is quite an interesting subject. Did we explain it to your satisfaction? Leave us a comment in the box below.