This is the second post in a continuing discussion regarding evaluating portfolio performance. In my last post, I discussed the benefits of diversification, and the importance of focusing on a portfolio’s over-all performance, as compared to the performance of the individual investments that comprise a portfolio. This time we’ll take a look at using yield vs. total return as a yardstick to measure portfolio performance.
Yield vs. Total Return.
Yield commonly refers to the cash generated by an investment without the need to invade principal. In other words, yield shows how much income has been returned from an investment based on initial cost, but it does not consider the changes in the underlying value of the investment since acquisition. Total return is simply the portfolio’s yield plus capital appreciation (or minus capital depreciation). Return on Investment (“ROI”) is a way to express total return as a percentage. ROI is calculated as follows:
ROI = (Yield +Capital Gains) / Cost of Investment)
Stock dividends and bond interest are the most common examples of investment yields. Investors who look to their investment portfolio as an important source of their day to day cash flow tend to concentrate their investments in dividend paying stocks and bonds. While living off the income generated by an investment portfolio without the need to touch principal is an attractive concept, it can also lead to a gradual erosion in the value of principal during periods of high inflation. If yield remains constant while the cost of goods and services are rising, purchasing power will be reduced.
Overweighting high yield investments such as dividend stocks, bonds, and real estate investment trusts also reduces a portfolio’s diversification because high yield investments tend to be closely correlated (i.e. to lose value at the same time). Certain market conditions, such as periods of rising interest rates, can put considerable downward pressure on all high yielding securities. As a result, putting too much emphasis on yield can lead to increased volatility in the value of a portfolio.
Return on investment is a better metric for evaluating a portfolio’s performance. As discussed in our prior post, portfolios that are diversified amongst investments that generate capital appreciation as well as those that generate income can be expected to generate greater return on investments over the long term. And although selling investments to generate spending money is often frowned upon, it is important to not lose site that both yield and capital gains generate cash flow. Moreover, in some instances, capital gains are taxed more favorably than dividends and interest.
Accordingly, investors should take care to avoid placing too much emphasis on yield alone. An over-concentration in high yield investments increases portfolio risk as well as the negative impact of rising interest rates. Instead investors should be focused on total return when evaluating portfolio performance.
That being said, it is very important to recognize that total return ignores the amount of risk that had to be taken to generate the return. This critical component of evaluating a portfolio’s performance will be the subject of our next post. Stay tuned!
 Note, however, that this simple calculation does not account for how long it took to generate the return. As a result, annualized return of investments should be used when evaluating investment performance. An easy to use online calculator you can use to calculate annualized investment return can be found here: http://www.moneychimp.com/features/portfolio_performance_calculator.htm