Defining Return on Investments

Are you confused by the terms: yield, interest, dividends, income, appreciation, and total return? If so, you are not alone. In the financial industry, professionals tend to throw those words around loosely assuming people know what we’re talking about. Let me help clarify the differences for you.

Let’s start with income. Dividends, interest and yield are all forms of income. Income tends to be more of a fixed number, although it can fluctuate to some degree. For example, interest accumulates on investments such as savings accounts, certificates of deposit (CDs), money market funds, fixed annuities and individual bonds (government, corporate and municipal). With the exception of certain types of bond interest (ie. municipals), this interest is considered income for tax purposes Another form of income is yield. Yield can be somewhat of a confusing term in that it is sometimes used interchangeably with interest. Yield is typically the amount of interest paid on a bond. We generally use the term “yield” or “yield to maturity” when talking about bonds. For example: if you own a 5% Pittsburgh Water and Sewer Bond, the yield is the same as the interest rate paid on the bond which in this example is 5%. However, if you buy the bond at a discount (less than par) or at a premium (greater than par) then the actual yield to maturity on the bond can be different than the interest rate. If you pay $1,100 for a $1,000 face value bond, you have paid more than what the bond is worth at maturity which is face value. This premium that you pay is deducted from your interest payments when calculating yield to maturity. In our example, the yield to maturity on this bond would then be less than 5%. In fact it would be 5% minus the premium.

Capital appreciation on the other hand occurs when your principal value goes up. It generally means growth as opposed to a form of income. If you focus on the bottom line of your statements each month to see how much your account has gone up or down, you are like most investors - concerned about the total return of their investments. Let me give an example to explain. Let’s say you buy a dividend paying stock for $10 per share. You hold the stock for one year and receive a 10% ($1) dividend. In addition, the value of the stock has increased by one dollar per share. This means your original stock investment has gone from $10 per share to $12 per share. You received income (dividend) of $1 and capital appreciation of $1 to bring your total earnings to $2 per share which represents a total return of 20%. Sound simple? To make it more confusing, if you sell the stock, the portion attributed to appreciation of your earnings ($1) is considered a realized gain for tax purposes. The $1 dividend you received is income and taxed as such which can be at a different rate than capital gains. By not selling the stock, your 20% gain would be considered an unrealized gain and subject to fluctuations over time.

And so, what is “return”? If the goal of your investment, regardless of whether it is a CD, bond or stock is growth, make sure you measure your total return. If your goal is simply to get the most income from your investment, then yield or interest is the most important measure of return. Just remember that comparing income investments to growth investments is really comparing apples to oranges. And as always, make sure you know your long-term investment goals and risk tolerance before deciding which types of assets make the most sense for you.