PART-2: The Yield on Cost Illusion
In 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:
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?
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.