Yield is what you earn from an investment in the form of regular, periodic income.
Investments produce cash for the investor two ways: growth and income. Growth is a rise in the price of the investment that results in an opportunity to sell it at a profit.
Income is payment to the investor for holding the investment and not selling it. This takes the form mainly of stock dividends or bond interest.
Yield is nothing more than a calculation of that income based on the total investment, typically over one year. Since your cash is tied up, it’s worth knowing what percentage of your money is being returned to you over 12 months. That number allows you to accurately compare different investments.
For instance, a stock purchased at $100 pays an annual dividend of $2. Thus you receive a dividend yield of 2% (2/100=0.02). Likewise, a bond that pays a 3% coupon means your investment of $100 will pay out $3 per year in interest.
Yield is an important factor when choosing an investment, but just as important is risk: How much risk are you taking to get that specific yield on an investment?
Stocks and bonds represent very different kinds of risk, and those risks will fluctuate over time and vary according to which stocks and bonds you choose.
The dividend on an established utility or telecom stock, for instance, is likely to represent less overall risk than a higher dividend from a tiny biotech or oil-drilling firm. A smaller, speculative firm might cut its dividend or go out of business entirely.
Taking a step back, the yield on any stock is fundamentally a higher risk than on a typical government bond. That’s because stocks represent companies that can go bankrupt, while bond-issuing governments rely on taxpayers and almost never fail to pay back their investors.
“Almost never” is an important caveat. There have been cases of municipal bonds, state bonds and even country bonds going sour. But these are rare compared to corporate shares losing value, which happens regularly to stocks.
Knowing how yield works can benefit your portfolio a number of ways. For one, the dividend payment on a stock is just part of what investors call total return.
First calculate the annual income yield on a stock in dollars. Then add the change in price over 12 months. Those two number together are total return, the actual gain you have experienced by owning the stock.
Many long-term investors choose to automatically reinvest their dividends into a stock, meaning they use that income to increase their ownership of the stock every quarter.
Likewise, investors seeking a better dividend yield sometimes see falling share values as a chance to buy more at a lower price. That increases your income and thus increases your total return from the stock.
For instance, the company with the $2 dividend you happily bought at $100 now trades at $50. The dividend payment has not changed. Your yield on that investment is no longer 2%. Rather, any new dollars you invest will pay 4% (2/50=0.04).
The topic of risk and return is a complicated one, but it can be made easier by investing primarily in index fund products which, besides being cheaper, produce a diversified return that includes growth and income.