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Don't Confuse "Yield" with "Total Return"© Sound Mind Investing | October 2010
To figure out whether a particular savings-type investment has been successful, ask two questions: First, how much interest income did you earn while waiting to get your money back? Second, did you get all of your original investment back, more than you put in, or less? The income you received while your money was tied up is called the yield. It's always expressed in "annualized" terms (i.e., what the investment pays over one year). Example: If you invested $1,000 in a 10-year bond and it paid $30 a year in interest, it yielded 3.0% per year — i.e., $30 ÷ $1,000. (Remember, a bond is like an IOU — a promise to repay after a certain period of time. The date the repayment is due is called the "maturity date.") With a bond (or bond fund), however, the yield is only one aspect of how well the investment performs. Let's say interest rates fell after you made your $1,000 investment. When rates fall, bond prices rise. As a result, you may have been able to sell your still un-matured bond after three years for a profit — say for $1,050. This would give you a $50 capital gain. When you combine your yield and your gain, the result is your total return. In our example, you invested $1,000 and received back $1,140 over three years ($90 in interest income plus the $50 gain). To gauge your total return in annual percentage terms, you need to figure out what rate of growth would turn $1,000 into $1,140 in three years. A financial calculator that performs time-value-of-money computations will show that it takes a 4.46% annual rate of return to do that. In other words, if you could invest $1,000 at 4.46% for three years (compounded annually), you would have about $1,140 at the end of that time. How did you get from a yield of 3.0% to a total return of 4.46% — almost 1.5 times better than the stated yield? By selling your bond investment for a $50 gain. The 3.0% yield you received as you went along plus the $50 gain at the end made it possible to achieve a 4.46% annualized total return, significantly better than the promised yield alone. But suppose interest rates had risen and the bond's price had gone down by $50 and you sold at a loss? That would have created a much different result. After three years, you would have $1,040 to show for your $1,000 investment ($90 in interest income minus a $50 loss). While you thought you were earning 3.0% a year, it turns out you were actually netting, on average, just 1.32% per year. So yield tells only part of the story. Total return is what you're really interested in. This information helps you understand why not all savings vehicles are interchangeable. Some fixed-income investments — e.g., insured savings accounts, CDs, and money market funds — do not fluctuate in value. You'll always be repaid what you put in, plus any interest you earned; there is never a loss of your original capital to worry about. However, other fixed-income investments, such as bond funds, do fluctuate. When you eventually sell, you're likely to get back more or less than you put in. In some situations, you could lose more on the sale than you received in interest. The unhappy result would be a negative total return. So for your emergency money, it's better to stick with money market funds or bank money market accounts that aren't subject to daily changes in value. For your accumulation fund, it's OK to go for the higher returns available from bond funds. But to minimize the risk of negative returns, be sure to match your expected investment time frame to the right kind of fund. For more, see For Savings You Won't Need to Draw On for Two Years or More and Mortgage-Backed Bond Funds: Higher Yields for Long-Term Savers.
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