Yield is for Farmers
How has this frequently irrelevant investment concept earned a consistently positive association, and misled so many people?
When you're working the land — from large wheat productions to tiny vineyards — you need to know your efficacy. How many bushels (or bottles of wine) are being generated per unit of land? What's the yield?
And when tracking the metrics, one should be both precise and consistent. It doesn't help to measure the number of grapes harvested per acre for one month, and then measure the number of bottles of wine produced per square meter, the next. We want consistent data, of high integrity, and that relays useful information.
Farm economics are an ideal laboratory for understanding yield because they typically rely on expensive machinery. If I have a unit of land that can generate $10,000 in profits each year, as long as I initially buy the right tractor, but the right tractor costs $40,000, I have a problem...
It takes me four years to produce the profits of the one-time tractor purchase.
The obvious way to increase my yield (i.e. "scale my business") would be with more land. Since I already bought the tractor, it's a sunk cost, and I don't have to do it again...so my "profit" on each additional plot of land is marginally higher than the profit from the original plot of land (because no additional tractor expense).
Another option to justify the tractor purchase would be if I can squeeze more than $10,000 out of my current land. Can I use better fertilizers, plant crops at more opportune times, or take better care of them — and maybe turn my $10,000 in profits into $20,000 in profits? Can I get a higher yield?
In both examples, the idea of higher yield is super appealing.
Many investors think about investing yield similarly — as if it's an obviously good thing...but it's not. You've been misled.
The reason is simple. The investment industry has multiple definitions for yield.
Here we discuss the ones you need to know:
DIVIDEND YIELD: if you own a stock, it might pay a dividend — your dividend yield is simply dividend amount / stock price [e.g. $5 dividend / $100 share price = 5% yield]. It's important to know that after a $5 dividend on a $100 stock, you don't have $105.
Dividends are paid out of investments, so the resulting portfolio is $95 stock + $5 cash.
Dividends are never contractually obligated, though some companies develop reputations for consistently paying them to shareholders. Dividends are income, and as such are taxable events.
DISTRIBUTION YIELD: if you own a fund (like a mutual fund or ETF), it will likely distribute some money back to you each year. Very similar to calculating dividend yield, simply divide that distribution by the share price of the fund.
Distribution yields come from funds which themselves have received income (like dividends) from the underlying assets they own — and are passing it on to you, the fund shareholder — and on which taxes may be owed by you. Distributions can also come from the fund itself selling underlying assets and locking in gains (called capital gains), on which taxes also may be owed, and also paid by you.
This is a huge problem in the industry. You need a very good argument to own a fund with high distributions.
High dividend yields and distribution yields are both unwanted — potentially costly, frustrating, and unnecessary. Why are these yields different than a farmer's yield?
Because dividends and distributions are not additional return for you.
They are a partial return of your investment to you.
Imagine it's a hot summer day, and you've invited a couple friends over. You walk down to the gas station and purchase a six-pack of beer. As you're leaving, the gas station attendant requires you to open one of the beers and drink it.
Do you want to drink a beer in the gas station?
Dividend yields and distribution yields don't allow you to choose the timing of the event.
Why do you want someone telling you when to drink your beer? You don't. Plus this income (just like income from a job) is taxable, so that $5 distribution will be taxed if it's held in a taxable investment account. If tax is 20%, you owe $1.
Now your $100 investment is $95 investment and $4 cash. Terrible.
Yet I could have started by saying, "I can get you a 5% yield!" and many investors' ears might perk. It's just linguistic gymnastics, without defining yield itself.
People think they're being given a free seventh beer, but they're actually being asked to drink the sixth beer on someone else's timeline. What you really want is for your investment to prudently grow, and for you to decide when to sell some of it (i.e. drink your beer), not for someone else to decide that for you.
These are bullshit yields. We really only care about our total return.
How much did my actual investment increase (in addition to any amounts that were forced back to me, which someone cutely, misleadingly, described as "yield")!?
BOND YIELD: this is not a bullshit yield.
Bond yields are critically important to your experience as an investor. But because the industry again simply describes them as yields — it's left to investors (and professionals guiding investors) to delineate that this is the meaningful yield.
Unlike stocks, bonds have contractual agreements that pay you income. If you've heard that "bonds are safer than stocks" but were never quite sure why, this is part of it...you begin to recoup some of your investment back immediately.
Bond yields are the gas station attendant still telling you that you have to drink a beer in the store, but he pulls a single from the fridge for you. You can take the six-pack home.
Yes, you have to take income — but it's ON TOP of your investment. It's not given to you via being deducted from your investment.
And thus, bond yield is like the yield of a farmer: more of it reflects more return. Risk and reward are related, and I'm not saying you should reach for high yields with your bonds. I'm just saying that bond yields are like a seventh beer, and dividend and distribution yields are not.
So the next time someone raves about a nice yield, just ask them.
Is it a bond yield, or is it a bullshit yield?
Am I farming, or are you making me tap into the six-pack while still in the store?
Precision matters. Language matters. We reap what we sow.