Can You Live Off Your Dividends? Part-2

PART-2: The Yield on Cost Illusion

The Yield on Cost IllusionIn Part-1 of this series, I examined the concept of dividend income as a viable means to support retirement income.  I asked the question “Does a 100% dividend stock portfolio support a retirement income?” In this post I considered whether the current dividend yield of blue chips stocks is enough to support retirement. Those actually living off their dividends, pointed out in the comments they were earning between 3% to 4% yield on their dividend stocks.

Some investors missed the entire point of the article. They confused the final value of their stocks and dividend yield, with their Yield on Cost (YOC). They failed to realize the single most important point:  When you retire you are living off the dividend income of your entire portfolio, not the YOC of your original investment. They used YOC to support double digit returns in retirement, far above the current dividend yield of the very stocks they were holding.

The reality is your current retirement income is based on the current dividend yield of the total value of your portfolio. The Passive Income Earner explained the concept most eloquently in his comment:

“Once you attempt at retiring, the amount of invested capital or ACB of your shares is irrelevant. You need to start looking at how much you have total. That total amount is what you are retiring with and consequently, that total amount is what your yield really is based on.”

“Let’s say you invested 100K in JNJ and in the end, it’s worth 500K. That 500K is really what you are drawing your retirement income from even though it’s generated from a 100K initial investment. The retirement rate of return and dividend yield for the purpose of retirement is based on your 500K at this point. (500K = JNJ share price * number of shares you own). Focusing on the 500K, the current yield of the stock is pretty much the market yield for that stock.”

“There is a difference between the growth of a portfolio with dividend and compound growth and the retirement aspect of that portfolio…”

So what exactly is Yield on Cost? And why do investors still confuse Yield on Cost with their current Dividend Yield?

What is Yield on Cost Anyway?

Yield on Cost (YOC) as defined by Investopedia, is the annual dividend rate of a security divided by the average cost basis of the investments. It shows the dividend yield of the original investment. It is calculated by dividing the most recent annual dividend payment to the average price that you paid for your shares. Dividend investors use yield on cost as a comparative means to demonstrate their increase of earnings over time. The problem arises when investors them assume YOC is their current rate of return.

Why Investors Get Confused

Dan Bortolotti discussed the yield on cost illusion in great detail in Debunking Dividend Myths: Part 6. Dan wrote in his article:

“Investment returns are expressed in annual terms, while yield on cost is a completely different measurement that doesn’t consider how long an investment has been held. If you confuse the two, you will quickly fall into the trap of believing that your investments are doing better than they really are. You might even think you’re beating the market.”

“Some of the issues I’ve explored in this series come down to differences of opinion, but not this one. The idea that dividend growth stocks will eventually “beat the market on yield alone” is nonsense, pure and simple. If this is the basis for your investing strategy, then you’re guaranteed to be disappointed.”

Investors easily get confused with YOC, because they forget two key points:

First, YOC is based on a period of several years – so it’s a cumulative return. For example, an investor will tell you with YOC they are earning a 15% return on a particular stock. The same investor will forget that 15% yield may be over a period of 5 or 6 years. The investor will overlay YOC to their current stock portfolio, and believe they are earning a much higher return. While taking a cumulative rate of return (YOC), and overlaying that to an annual rate of return (Dividend Yield) defies logic, many investors still continue to do exactly that.

Second, YOC is always going to result in an inflated yield. YOC compares the most recent dividend (which is usually the highest) to the original share price (which is usually the lowest).  For this simple reason alone, YOC will usually be higher than the current dividend yield. You can see this in my GIC example below.

Creating a YOC Illusion: The GIC Example

If you need further proof that Yield on Cost distorts returns and tells you very little, consider the following example. GIC’s currently have the lowest rate of return, with no capital appreciation. Yet you can create higher returns using YOC when investing in a 5 year GIC. In this example I use an annual rate of 3.5% (ING Direct) and invest for 10 years, with the interest compounded annually:

Year Rate Start Interest End YOC Total Return
1 3.50% 1,000.00 35.00 1,035.00 3.50% 3.50%
2 3.50% 1,035.00 36.23 1,071.23 3.62% 7.12%
3 3.50% 1,071.23 37.49 1,108.72 3.75% 10.87%
4 3.50% 1,108.72 38.81 1,147.52 3.88% 14.75%
5 3.50% 1,147.52 40.16 1,187.69 4.02% 18.77%
6 3.50% 1,187.69 41.57 1,229.26 4.16% 22.93%
7 3.50% 1,229.26 43.02 1,272.28 4.30% 27.23%
8 3.50% 1,272.28 44.53 1,316.81 4.45% 31.68%
9 3.50% 1,316.81 46.09 1,362.90 4.61% 36.29%
10 3.50% 1,362.90 47.70 1,410.60 4.77% 41.06%

By Investing in a GIC only giving me a 3.5% return, and reinvesting the earned interest, I was able to create a Yield on Cost of 4.77%. Although a small return compared to a dividend stock, there is no magic here. It’s a simple example of compound return. In fact, my annual rate of return never changed from 3.5%.  What did change was the value of my investment over time, or my total return (41% over a 10 year period).

If a simple GIC has an increasing yield on cost with no dividend increases, then what exactly is yield on cost telling you?

Conclusion

Dividend investors use yield on cost (YOC) as a comparative means to demonstrate their increase of earnings over time. The problem arises when investors then assume YOC, and not the current dividend yield, is their current rate of return. They believe they are actually earning double-digit rates of return, which far exceeds the current dividend yield of the very stocks they are investing in.

The Danger with YOC is investors believe they are achieving returns they are not.  You might be surprised to hear that coming from an investor, whose equity portion is 80% dividend paying stocks! Yet when I track my investments YOC has no bearing on my current return.

The question that comes to mind is if YOC generates such high returns, why isn’t everybody using it? Why are all the traders at Goldman Sachs not using YOC? Why are big banking firms in Asia and Europe not buying anything but dividend stocks? Why do other investors have such low returns when dividend investors are doing so well? The reality is there are no double-digit returns. Yield on Cost is an illusion.

In Part-1 of this series, I examined the concept of dividend income as a viable means to support retirement income.

18 Responses to “Can You Live Off Your Dividends? Part-2”

  1. MoneyCone

    Apr 29. 2011

    So many investors have a hard time understanding this not-so-subtle difference! You’ve explained this beautifully with the GIC example!

    Reply to this comment
  2. The Dividend Ninja

    Apr 29. 2011

    @MoneyCone Thanks! Since YOC really confuses investors, I really felt it needed to be discussed.

    Reply to this comment
  3. Dividend Mantra

    Apr 30. 2011

    Excellent article Ninja. I agree with your statement that using YOC could confuse or mislead investors to think they are having better returns than they actually are. However, I think it’s still important to track this metric for dividend growth and compound growth factors.

    To use the JNJ illustration, whether you are using YOC on the $100k initial investment or current yield on the $500k current value, it’s still the same amount of cash you’re receiving. You’re just using a different metric to track that amount.

    Good stuff!

    Reply to this comment
  4. The Dividend Ninja

    May 01. 2011

    Thanx for posting Dividend Mantra 😉

    Reply to this comment
  5. I still find yield on cost useful, but i doubt that many investors confuse yield on cost with total returns. If some do however, i won’t be too surprised.

    Why do i find YOC useful? Well imagine i purchased $100K worth of a dividend growth stock 24 years ago. The stock raised distributions by 6% per year, and it yielded 3% when i bought it. Inflation is 3%, and the actual dividend growth is 9%, so my real growth is 6%. My goal is to generate $1,000 in income ( in 1987 dollars). In 1987 I will generate $3,000. Big deal. My yield is 3%. T-Bonds and high yield stocks like utilities and telecoms yielded 8% in the late 1980s. Everyne makes fun of me for being a lousy dividend investor.

    In 2011, this same investment generates $24K/year. This is a YOC of 24%. Now the current yield is still 3%, but the stock has gone up proportionally and its now worth $800K. In real terms ( 1987 dollars) this same investment is generating $12,000. Investors in bonds and the high yield stocks are getting an yield on cost of 8%, but their real income has decreased purchasing power – about 50% lower than 24 years ago.

    The company is still generating higher revenues, which leads to higher profits, which leads to higher dividends. The current yield is 3%, but why do i care? I only care if I want to invest new money in the stock.

    The above amounts are highly hypothetical. In real life, nothing is straightforward, even dividend growth, total returns etc.

    The more important part is that everything is interrelated. YOC, with dividend growth, total returns, current yield, stock valuation and analysis, projecting dividend income etc. Investors looking at just YOC, or dividend yield, or dividend growth would surely miss the big picture. People spend plenty of time discussing whether YOC is relevant or irrelevant, and that seems to be an exercise in missing the forest for the trees.

    The goal of every dividend investor should be to one day somehow manage to live off dividends. By focusing on attractively valued stocks, with EPS and DPS growth potential they are now one step closer to achieving their goals. Of course all the research would be useless if investors fails to act on the knowledge they gain, due to little and unimportant things.

    As Nike commercials say: “Just do it”.

    Reply to this comment
  6. My Own Advisor

    May 05. 2011

    Great article man. Equally great example. The reality is, you’re not paid on what an investment cost you. You’re paid on what the investment is actually yielding.

    All that said, I hope to have enough dividend income someday never to worry about artifical yield on cost calculations and dare I say it, worry about how much each investment is actually yielding. As long as my overall portfolio is hovering around 4%, that will be more than fine for me.

    I bet our friend Susan Brunner doesn’t give a hoot about YOC, she just watches those dozens of cheques arrive in the mail ever month and goes from there 😉

    Reply to this comment
  7. The Dividend Ninja

    May 05. 2011

    @MOA, Cheers!

    Reply to this comment
  8. Coreed

    Jan 01. 2012

    From your article:
    ‘By Investing in a GIC only giving me a 3.5% return, and reinvesting the earned interest, I was able to create a Yield on Cost of 4.77%’

    YOC has nothing to do with reinvesting anything. It is current dividend payout / purchase price. Pure and simple.

    Reply to this comment
  9. Victor

    Jan 02. 2012

    Excellent article

    This article sort of reminds me of a chapter I read in the Wealthy Barber returns; the misconception that some folks have when investing in real estate. For instance, if one were to purchase a property at 50k and after 40 years they sell it for 200k, they would tell you that an investment with those returns can’t be beat! In actuality the return on those numbers is only 3.6% over that duration (not including maintenance, renos, etc).

    Reply to this comment
  10. S. B.

    Sep 02. 2012

    Thank you for writing this. Personally, I am tired of hearing about YOC in many articles. I have never understood why people use that measure since it does not use the current price of the stock. The market does not know or care the price at which I bought some stock long, long ago!

    Reply to this comment
    • The Dividend Ninja

      Sep 02. 2012

      S.B. I completely agree. Dividend investors tend to use YOC as a comparitive means to help dtermine which stocks have solid dividend growth, or sustained growth.

      But in the end, your ROI (return on investment) which is a total return, will clearly tell you which stocks are performing well or not. In addition many investors who use YOC completley forget the time period they have held and investment. In other words a YOC of 42% is meaningless unless you know how long the investment was held. I’ve often scratched my head trying to figure out why YOC is meaningful.

      Cheers 😉

      Reply to this comment
  11. Neil

    Oct 16. 2013

    Thank you! I’ve been using YOC and didn’t realise that it was wrong. Of course it’s wrong and now I see why! Thanks,

    Reply to this comment
    • Dividend Ninja

      Oct 16. 2013

      Neil, thnk you!

      Every time I hear YOC come up I keep scratching my head as to why it so meaningful to dividend investors.

      you can get much more meaningful comparisons through looking at the Dividend Growth Rate over 5 and 10 year periods, and your Total Return on Investment (ROI).

      I use ROI as a compartive measure, because it accounts for both share-price and yield. Since I have low-yield to high-yield stocks, dividend growth stocks, and everything in between, ROI gives me a better compartive measure.

      Cheers. 😉

      Reply to this comment
      • Dividend Ninja

        Sep 08. 2016

        “Every time I hear YOC come up I keep scratching my head…”

        This would explain why I don’t have any hair on the top of my head.

        Reply to this comment

Trackbacks/Pingbacks

  1. Weekend Reading 5/1/2011 — Dividend Monk - May 1st, 2011

    […] The Yield on Cost Illusion Dividend Ninja points out the confusion that sometimes arises with yield on cost. […]

  2. Weekly Blog Round: Your Money & Your Dividends « The Passive Income Earner - May 1st, 2011

    […] Dividend Ninja with ‘Can You Live Off Your Dividends? – The Yield On Cost Illusion‘ […]

  3. What’s New Around The Blogosphere: May 6th, 2011 | Boomer & Echo - May 5th, 2011

    […] Ninja concludes his Can You Live Off Your Dividends […]

Leave a Reply

*