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Total return and current yield

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Price change plus what it paid you, divided by what you started with. Forget the income and you fail the question.

Return has two halves, and measures differ on which they count

Anything an investment gives back arrives in one of two forms. It pays income — a dividend on a share, a coupon on a bond — or it changes in price, producing a gain or a loss. Every return measure is a decision about which of those two halves to include and what to divide by, and getting a question right means noticing which decision it has made.

Total return includes both halves. It is the ending value minus the starting value, plus the income received, all divided by the starting value. It is the honest measure of how an investment performed, and it is the one that catches out anyone who reads only the price. A share that fell slightly while paying a large dividend can have a positive total return. Taxes are not in the formula; working out an after-tax return is a further step. Fees are different: FINRA reminds investors that an accurate figure for their own return counts the transaction fees they paid to buy and, once they have sold, the fees paid to sell.

Current yield includes only the income, and it divides by the current market price rather than by the original cost or the par value. It answers a narrower question: what income is this investment producing right now, relative to what it would cost to buy today. That is why a bond’s current yield rises as its price falls, even though the coupon has not moved at all.

The most common error in this topic is a missing term rather than a wrong formula. Candidates compute a price return, call it total return and lose the mark. Before calculating anything, list the income received and the two prices, and then decide which of the three the measure in front of you actually uses.

There is a rule behind the way a fund is allowed to advertise this figure, and it exists because a total return can be made to say almost anything by choosing the period. An investment company advertisement that gives performance must show average annual total return for one, five and ten year periods — or for however long the registration statement has been in effect, if that is shorter — computed by the method the registration form prescribes, current to the most recent calendar quarter before the advertisement was submitted, and set out with equal prominence. Equal prominence is the operative phrase: a poor five-year figure cannot be shrunk to make a good one-year figure look like the whole story.

Exam terms

Total return
Price change plus income, divided by the starting value.
Price return
The change in price alone, ignoring income.
Current yield
Annual income divided by the current market price.
Income
Dividends or coupons actually received over the period.
Starting value
What the position was worth at the beginning; the denominator of total return.
Realized and unrealized
Whether a gain has been sold or is still on paper; total return counts both.

What each measure counts

What an investment gave backIncome received, plus any change in price
  • IncomeDividends and coupons received
    • Counted by total return
    • Counted by current yield
    • Ignored by price return
  • Price changeGain or loss on the position
    • Counted by total return
    • Counted by price return
    • Ignored by current yield
  • The denominatorWhat you divide by
    • Total return: the starting value
    • Current yield: the current market price
Two halves, and each measure takes a different pair.

Try it: Write down three numbers for a holding you invent: what it was worth at the start, what it is worth now, and the income it paid. Then compute all three measures from those numbers and say which one is highest, which is lowest, and what a question would have to say for each to be the one it wanted.

A number needs something to be measured against

A total return of nine percent is not yet an answer to anything. Nine percent against what? That is what an index is for. A market index tracks the performance of a specific basket of stocks representing a particular market or sector, and the exam expects a handful by name: the Dow Jones Industrial Average, an index of 30 blue chip US company stocks; the Standard and Poor’s 500, which tracks large US stocks; the Russell 2000, another benchmark that tracks a particular market segment; and the Wilshire 5000, which takes in most publicly traded US stocks.

An index becomes a benchmark the moment it is used as the standard against which one investment’s performance is judged. Benchmarks provide that standard, and choosing the appropriate one is the whole of the skill: if you are evaluating a large-capitalization US stock fund, the S&P 500, which tracks large US stocks, is a relevant benchmark for it.

Get the match wrong and the comparison measures the wrong thing. Judge a small-company fund against the Dow and the gap you are looking at is mostly the difference between two markets, not a verdict on the manager. The rule to carry into the exam is short: the benchmark has to hold the same kind of thing as the portfolio, or the number it produces is about the index rather than about the investment.

How an index weights its members decides what moves it. Many indexes weight by market capitalization: share price times shares outstanding, so larger companies count for more. Some, such as the Dow Jones Industrial Average, are price-weighted: the price per share sets the weight. In a price-weighted index, a 10% rise in a $300 stock adds ten times as much as a 10% rise in a $30 stock, because the dollar move is ten times larger.

Exam terms

Index
A measure tracking a basket of securities representing a market or sector.
Benchmark
An index used as the standard against which one portfolio is judged.
Dow Jones Industrial Average
An index of 30 blue chip US company stocks.
S&P 500
An index tracking large US stocks; the usual benchmark for a large-cap US fund.
Market-cap-weighted index
Weights each member by share price times shares outstanding.
Price-weighted index
Weights each member by its price per share, as the Dow does.
The ruleTotal return = (end − start + income) ÷ start. Current yield = annual income ÷ price. A benchmark only measures the investment where it holds the same kind of thing.

The closest contrast

Price return: leaves income out.

Total return: keeps it.

The distinction decides whether an answer is right or merely close. A question that mentions a dividend or a coupon and then asks for return is almost always asking for the measure that uses it.

Worked example

A share is bought at $80, pays $3.20 in dividends over the year and is worth $78 at the end of it.

  1. Identify the three inputs before calculating. Starting value $80, ending value $78, income received $3.20.
  2. The price change is $78 − $80 = −$2, so the price return alone is −$2 ÷ $80 = −2.5 percent, and an investor who stopped there would report a loss.
  3. Total return adds the income: (−$2 + $3.20) ÷ $80 = $1.20 ÷ $80 = 1.5 percent. The holding gained despite the falling price.
  4. Current yield answers a different question again: $3.20 ÷ $78 = 4.1 percent, using the current price rather than the original cost.
  5. Three defensible numbers come out of the same facts, and only one of them answers any given question. Reading which measure was asked for is the whole skill.

Check yourself

Try a question, then read the explanation to review the rule.

Opening your study record…

Same rule, new context

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Summary

  • Total return is the price change plus income, divided by the starting value.
  • Price return leaves income out and understates any income-paying holding.
  • Current yield is annual income divided by the current market price, so it rises as price falls.
  • Identify the income, the starting value and the ending value before choosing a formula.

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