Yield is a measurement to describe how profitable an investment is. The formula examines an arbitrary time period – usually a period of one year. The formula to calculate the current yield of an investment gives you a percentage. And the higher this percentage is, the higher the yield of your chosen investment.
By its nature, the theory of yield assumes that the growth or trend it describes will remain constant. If you invest in an asset because of its current yield, you expect the investment to yield as much in the near future as it has in the time frame that was used to calculate the yield percentage.
Using yield to choose which assets to invest in narrows your options as it can only be used to assess investments that produce an interest rate or pay dividends.
One factor which is essential to any investment decision is risk. This is also true if you seek to invest based on yield percentages. Investors typically associate higher-risk investments with a higher yield potential. Generally, hedge funds are riskier than mutual funds or ETFs. But they also offer a higher yield potential, which in turn can grow your principal investment in a shorter time frame. This allows you to invest in more assets to further grow your wealth.
From an investor's perspective, yield can be a key metric in two scenarios. The first is when you're in the earliest investment stage when you decide which assets to put money into, especially if the goal is short- or medium-term gains. If you're looking to increase your cash flow quickly, high-yield investments are the way to go. High-yield investment options are more likely to create quick gains on initial investments.
Yield and higher-yielding investments are a hot topic for discussion between dividend investors and value investors. The long-term approach for growth with safe investments that value investors rely on runs contrary to high-yield, shorter-term gains which dividend-oriented investors strive for.
The other scenario in which yield is a key metric to look at is in anemic or slow-growing market circumstances – a situation which happens mostly during recessions or when economies slow down – these are financially unstable and uncertain circumstances. General money market or stock market instability leads investors to turn to yield as a metric for choosing investments. This works as a hedging strategy protecting investors and their investments from high market volatility and increased risk.
Volatility and risk are also reasons to consider yield a key metric when investing in a sector or industry. As soon as these grow, despite a volatile economic climate, investors who have decided to invest in them due to yield-driven decision-making may benefit from increasing, dividend-paying gains.
If you want to use yield as a defining base metric for investment decisions, it should fit your investment strategy. If you're looking to increase your income in a shorter time period at a medium level of risk, it's perfectly fine to use yield. On the other hand, investors who seek long-term gains and don't shy away from holding onto assets in the long term (and usually seek to diversify their portfolio with various asset classes such as real estate, dividend stocks, or ETFs) are better off calculating with other metrics and baselines.
There is a simple formula that you can use to calculate cash flow based on your initial investment amount. The time frame you choose to calculate the yield usually consists of a business year, but other variations are possible – for example, calculating quarterly or even every month.
The basic formula for yield is: Net realized return ($) / Principal investment ($) = Yield (%)
Let's look at an example to break the formula down even more: You have used a robot advisor to purchase shares on the stock market. You initially bought ten shares at a stock price of $100 each. After a year, you sell your shares for $1200. Additionally, you receive an annual dividend of $1 per share, which comes to $10 in total dividends. To get the net realized return, you have to add your total dividends to the selling price of all 10 shares. This sum is then divided by the initial share price. Applying the formula, we arrive at a total yield of: ($200 + $10) / $1000 = 0.21 or 21 %.
Things to Keep In Mind
Since high-yielding investments generate higher amounts of cash flow and income, a high value is often seen to indicate a low-risk investment. But you have to keep in mind the underlying yield calculation. The impressive value may have resulted from a drop in market value, which should be a point of concern for investors.
Also, a high yield percentage can result from a large dividend income or decreasing stock prices. Increasing dividends, in turn, have to be taken with a grain of salt as they could result in rising stock prices. This is because they are based on the earnings a company has made.
The combination of high stock prices and high dividends usually leads to only marginal but consistent rises in yield. If yield grows significantly despite these circumstances, this can indicate short-term cash flow problems for the asset, which could be detrimental for investors.
There are three defining factors for different yield types:
- Investment duration
- Return amount
- Type of asset
There are two important metrics for stock-based investments: YOC – yield on cost – and current yield. Cost yield is calculated with the original purchase price. However, current yield uses the current market price instead of the purchase price. Rising stock prices lead to a decreasing current yield.
If you invest in bonds that pay returns annually – no matter if they are corporate bonds, government bonds, or municipal bonds – you can determine nominal yield with the following formula: Annually earned interest divided by the bond's face value equals the nominal yield. But this doesn't apply to bonds with a floating interest rate.
Three Special Types: YTM, YTW, and YTC
YTM or "yield to maturity" is a specific measuring tool for bonds held until their maturity date. The value is seldom subject to change and is expected to stay stable and consistent until the bond reaches its maturity.
Yield to worst describes the lowest possible yield potential without it defaulting. It works on a worst-case basis and is used for risk measurement to secure the investor's minimum income requirements even in the most dire of circumstances.
Callable bonds – special bond funds – are redeemable before reaching their fixed maturity date. YTC or "yield to call" refers to the bond's yield value at the specific time when it's called. To determine this yield value, you must include market price, interest rate payments, and the duration until the call date because the interest amount is defined by that period.
Short answer: It depends. If you’re using yield as a base metric for your investment decisions and to build your portfolio, then it has to fit in with your general investment strategy. If you're looking for long-term growth with high annual dividends, stable income, and a portfolio diversified to a certain degree - other metrics and values are more useful. But for other strategies and agendas, it is a suitable guiding metric.
If you know your way around the world of finance, high-yielding quant hedge fund strategies with low minimums and 15%+ targeted returns are a great way to diversify, no matter what metric you use. Invest in CARL's sophisticated strategies to grow your wealth and set yourself up for a prosperous financial future.