A year or so ago, I remember having a discussion with a former colleague about the performance on a certain mutual fund. As we were going over the numbers on the fund’s fact sheet, he finally asked me, “So what is the difference between annual return and yield?” Being that he had worked as an advisor for a major brokerage firm for many years, I initially thought he was kidding. But by the puzzled look on his face afterwards, I quickly realized that he truly had no idea. Without poking any fun, I explained it to him as simply as I could.
Since then, I have had other clients ask me the same question. As advisors, we use the two terms often and I think people sometimes believe that a portfolio’s annual return and a portfolio’s yield are both one and the same thing. This is not the case. Although each can be used to describe the overall performance of an investment or portfolio, the two terms differ in regards to specific time periods, (the past and the future).
“Return” expresses what an investor has actually earned on an investment in the past. This includes capital gain, interest, and dividends combined. “Yield”, on the other hand, just focuses on what the investment will pay the investor in the future. So, if you own a portfolio of stocks and bonds that is yielding 3%, but earned you 8%/year over the last decade, you know two things.
1. the total of all capital gains, interest, and dividends over the past decade averaged out to 8%.
2. if you continued to hold the portfolio unchanged for one year, you will earn 3% of interest and/or dividends of what the overall portfolio value is at that moment in time.
In looking backwards, the yield the portfolio generated in the past has already been calculated into the 8% return the investor has seen. But in looking forward, you can only calculate what the yield will be, (based on the current value of the portfolio and the amount of income the portfolio is expected to pay). We have no idea what the value of the holdings in the portfolio will be in the future. But we do know what those holdings will pay us if we continue to hold them. If we end up holding that same portfolio for another year and the price of the securities goes up another 10%, the return would end up being 13% on the year, (10% gain + 3% yield = 13%). Understanding this concept becomes important when looking at certain investments, (stocks, bonds, mutual funds, exchange–traded funds, etc). Knowing what a portfolio has earned in the past and knowing what the portfolio will yield in the future can certainly help investors make smarter, and more informed decisions.
