How to size up alternative rates of return on that nest egg of yours
You have a sum of money - say $1,000 or so - you want to sock away for a year or less. In figuring out where to put that nest egg - in a high-flying stock or a relatively sedate but accessible money market fund - you'll want to know the rate of return on your investment. How much is the bank or the company going pay for the use of your money?
On a lunch-hour stroll past the bank, it's easy enough to spot its interest rates in the window. Nowadays, a minimum $2,500 deposit in a money fund account will earn about a 10 percent annual return, or yield. (Yield is the rate of return on any investment expressed as a percentage.)
So in a year, your $2,500 investment would grow by $250, to $2,750 (assuming annual compounding). Simple enough.
A money market fund, which now yields about 10.5 percent annually, is a similar type of account. Both investments typically allow you to write a limited number of checks and are very liquid, which helps reduce risk. Bear in mind, however, that the 10-percent rate is not guaranteed to stay the same for a year. Rates on the money market fund, which may have a lower minimum deposit than the bank money market deposit account, fluctuate daily. Bank money fund rates change every week or so. Also, the liquidity may be tempting, but if you withdraw any of your investment, your return will be reduced.
If your tastes run to higher returns (and the inherently greater risk associated with participating in the free-enterprise system) stocks may please your investment palate.
You may have noticed in the local newspaper's daily stock listings that one of the columns is entitled ''Yield.'' Unlike the notice in the bank window, this is not an annual rate of return for investing in this stock. The ''yield'' is the percentage return based on dividend payments only.
For instance, if the fictional company Potential Ltd. is selling at $20 a share and annual dividends total $1.80, the yield listed in your local paper would be 9 percent. This is calculated by dividing the dividend by the stock price.
Since the yield is based on the current price of the stock, remember that if the stock price or the dividend changes, so will the yield. If Potential reports higher than expected earnings tomorrow and the stock rises to $21, the dividend yield will become 8.5 percent. Eventually, those higher earnings may translate into higher dividend payments, thus raising the yield, but it will depend on management policies and plans for the company.
This dividend yield gives one a starting point for comparing returns. When looking at a stock based on the dividend yield, there are a number of considerations to keep in mind.
For example, preferred stock dividends are typically fixed. Like bonds, the returns usually don't vary, whether the company has a good year or a poor one. On the other hand, common stock dividends do offer the potential for future dividend increases, but you sacrifice some of the security of preferred stock dividends. If Potential Ltd. has sluggish sales, the common stock dividend will probably reflect the apathy.
Also in assessing the dividend outlook, examine Potential's past management policies. Does it have a long history of consistent dividend payments? How much has the dividend grown each year?
Stocks of companies that consistently pay high dividends are known as ''income'' stocks. Typically telephone and electric utility stocks fall in this category. Stocks that don't pay dividends may be ''growth'' stocks. Here, all earnings are plowed back into the company and, one hopes, the stock price grows as a reflection of this policy.
In any stock, you're probably looking for more than just consistent dividends; you want the stock itself to appreciate.
Before you plunk down $20 a share on Potential Ltd. and earn 9 percent on the dividend returns, you want to calculate how much the stock itself needs to rise to earn a return competitive with other investments.
If Potential goes to $23 a share and you decide to sell, your rate of return will be 15 percent on the sale alone (not including dividends). This figure is arrived at by dividing the gain ($3) by your purchase price ($20).
Assuming you sell the shares after recieving dividend payments, your investment yield would be 24 percent: 15 percent for the stock sale plus 9 percent gain on dividends. But don't forget to allow 1 to 2 percent of your purchase price for the broker's commission
A closing caveat: It's more fun to take examples that present a positive-return scenario. It's probably more instructive, however, to plug some lower-than-purchase-price figures into the examples to get an idea of the risk involved. A drop in stock price of $1 a share will cut your 9 percent annual dividend gain to just a 4 percent total return - again, that's before adding brokerage costs.