Sometimes writing this blog and interacting with the regular readers, forum moderators, financial professionals, and other bloggers it's easy for me to forget that the average level of financial literacy among docs, even extremely intelligent, talented physicians, is not that high. This usually becomes evident to me in curbside, real-life financial consultations, emails, or at speaking gigs.
I had a recent curbside discussion with a doc where it became evident the doctor didn't know the difference between investment “Yield” and “Return” and it seemed that a financial professional (okay, who are we trying to kid, he was a salesman of financial products) was taking advantage of that lack of knowledge.
Yield Does Not Equal Return
Here's the most important point — yield does not equal return. The yield of an investment is only one component of the return, the other one being the capital appreciation or capital gain. Bear in mind that either or both of these parts of a return can be positive or negative. Ideally, they're both positive and very positive at that. Yield is what an investment pays you in any given time period, typically one year. Capital appreciation is the difference between what an investment was worth a year ago and what it is worth now.
Let's run through some examples so you can understand what I'm talking about.
A Certificate of Deposit
Let's assume you buy a CD with a yield of 1.5%. The bank (and the FDIC) guarantees the principal won't go down in value. It also isn't going to go up in value, at least if you hold it the entire term.
Yield: 1.5%. Capital Appreciation: 0% Total Return: 1.5%
A Bond When Rates Increase
Now, let's say you buy a treasury bond with a yield of 3% and a duration of 5 years and interest rates go up 1%. The value of your bond falls 5%.
Yield: 3% Capital Appreciation: -5% Total Return -2%
A Bond When Rates Decrease
Now, let's assume the opposite occurs with that 3% bond, rates go down 1%. Now your bond is worth more.
Yield: 3% Capital Appreciation: 5% Total Return: 8%
Consider a paid-for investment property. Let's say your gross rents are $12,000 a year, and your expenses are $5,000 a year. Thus, your yield is $7000. If the value of the property at the beginning of the year was $100,000 at the beginning of the year, and $102,000 at the end of the year, then you get this:
Yield: 7% Capital Appreciation: 2% Total Return: 9%
If expenses one year were particularly high, it's quite possible your yield could be negative. That would mean you had to pour some money into the investment.
Let's say you owned a share of Apple in 2014. It paid out dividends worth 1.67% of the share price that year.
Yield: 1.67% Capital Appreciation: 40.03% Total Return: 41.70%
In 2015, it wasn't nearly as exciting.
Yield: 1.93% Capital appreciation: – 2.80% Total Return: -0.87%
Reaching For Yield
People get in trouble when they engage in a practice called “reaching for yield.” This is when people invest in something just because the yield is higher, without paying any attention to the total return. As Will Rogers said, “I am not so much concerned with the return ON my capital as I am with the return OF my capital.”
A classic example might be a junk bond fund. Consider Vanguard's fund (which is actually very safe and well-run compared to most junk bond funds.) Back in 2000, a share was worth $7.32. It is now worth $5.69 (2016). Compare that to a safer bond fund, such as Vanguard's intermediate treasury fund, where the share value increased from $10.11 in 2000 to $11.58 today. Yes, the junk bond fund has a higher yield (currently 5.40% versus 1.15%) but that doesn't necessarily mean the total return will be higher because the junk bond fund is EXPECTED to go down in value over the years due to defaults, even in the falling interest rate environment that caused the treasury fund to actually increase in value. In this case, the junk bond fund has had a higher return than the treasury fund (6.34% to 5.12% per year over the last ten years) because the difference in yield was more than the difference in capital appreciation.
Dividend-focused stock investors are classic yield chasers. They choose stocks entirely based on the dividends they pay because they feel the dividends will be more stable than the stock price. The data actually looks pretty good in retrospect, but that's primarily due to the value effect, and it turns out there are better ways to get a high “value factor” than using dividends.
Even in “dividend investing” your total return is what really matters. You can always declare your own dividend by selling shares if you would prefer an investment where a larger percentage of the return comes from yield rather than capital appreciation. If you prefer the opposite, then just reinvest the dividends. In a tax-protected account, it's all the same. In a taxable account, you're actually better off with a lower-yielding investment most of the time on an after-tax basis.
Back to the curbside consult that started this post. In this case, a Wells Fargo “advisor” was pushing one of their proprietary products (with a wrap fee of 2%+) that was designed to be a high yield investment. This was their “multi-asset class income portfolio” that is composed of a bunch of investments selected primarily for their yield. These included stocks with a yield of as much as 4.34%, “business development companies” with a yield as high as 10.91%, master limited partnerships, REITs, preferred stocks, a couple of individual corporate bonds, and some bond ETFs you could buy yourself for 20 basis points.
Overall, it was about a 60/40 portfolio that seemed to be built primarily to be sold to someone who didn't know the difference between yield and return. The overall advertised yield was 4.14%. Of course, after you pay your 2%+ wrap fee, that's really 2.14%. Be careful what you ask for. If enough other people ask for it too, someone will make it and sell it to you.
Here's another example, also from Wells Fargo. It is called their “Multi-Sector Income Fund” that I just happened to run across while doing this post. It is a closed-end mutual fund with a high expense ratio of 1.24% and a current yield of 9.3%. That must be an awesome investment with that high yield, right? Well, if you look at the total returns for the last five years it has been 4.04% per year. That must be really disappointing to people who bought it thinking that because it had a yield of 9% that it would have a return of something like 9% (or more.)
Yield is not return. Return is not yield. Return is yield + appreciation (or depreciation.) Know the difference when evaluating investments.
What do you think? Have you or do you know someone who got burned reaching for yield? What happened? Comment below!