How does investments make money?

Investing outside of retirement funds

After two years of saving and sacrifices – sweat and overtime – you finally accumulated enough money to start investing outside of your retirement funds. You just spent the afternoon with your new broker, as he or she presented a myriad of investment choices with you, explaining each in detail and having your head spinning!

Your broker presented you with several hypothetical scenarios describing the overall rate of return you might expect to receive in each case, until you finally decided to buy shares in a local company that you know a little about.

But, as you walk away from his or her office, you start thinking: “what will I get exactly and how will I get it?”

Key Points to Remember

• When considering an investment performance, it might sometimes be easy to be distracted by the simple return (or should have returned).
• Investments, can however generate other forms of value on top of capital gains, including interests, dividends and sometimes tax breaks.
• Instead of simply taking into consideration the price change, you must consider all value fluctuations, in what is called “Total Yield “ of an investment.

Interests

Interest income is paid on any type of debt instrument as compensation for the loan of the investor's capital to the borrower or issuer. This type of income is paid by several different types of investment, listed as follows:

• Fixed income securities, such as DC (Deposit Certificates) and bonds. The interest rate is usually predefined and lasts until the security matures or is called or sold.
• Cash deposit accounts, such as chequing accounts, savings accounts, and monetary accounts. Depositors receive interest as compensation for "parking" their money in the account of the depositary institution.
• Fixed annuities, which pay a fixed interest rate with tax deferral until maturity.
• Seller-financed mortgages, where the seller charges an agreed interest rate on the principal loaned to the buyer.
• Mutual funds that invest in the above vehicles.

There is no form of equity of any kind. Each of these debt instruments pays a declared interest rate. This rate is generally fixed but can vary according to the conditions of the investment.

The rates on sight deposit accounts generally fluctuate with changes in interest rates, while the rates on bonds, Deposit Certificates and fixed annuity contracts generally remain constant until maturity. Interest-bearing investments are always linked to current interest rates and cannot, by their very nature, pay rates high enough to beat inflation over time, unless they are high-risk vehicles such as junk bonds.

Most interest-bearing securities carry a rating, such as AAA or BB, assigned by one of the major rating agencies, such as Standard and Poor's (S&P). If this rating drops after the issuance of a security, this could be a possible indicator that the issuer will fail to comply with its obligations. A significant drop in income, profits or cash flow could be another warning sign. Of course, in many cases, these changes will result in a lower grade.

Dividends

Dividends are a form of cash compensation for equity investors. They represent the portion of the company's profits that is returned to shareholders, usually on a monthly or quarterly basis.

Dividend income is similar to interest income in that it is generally paid at a specified rate for a specified period. But dividends are only paid on stocks or on mutual funds that invest in shares; however, not all shares pay dividends. In general, only established companies pay dividends, while smaller companies generally retain their liquidity for future growth.

Dividends are paid on common and preferred shares, although the rate is generally higher on preferred shares than on common shares. Dividends can also be either ordinary, which are taxed as ordinary income, or qualified, which are taxed as long-term capital gains. In most cases, companies are not required to pay dividends, at least on common shares. Since dividends are based on corporate income, low cash flows or profit margins may signal an impending reduction or failure to pay dividends to shareholders.

The yield on dividends may vary depending on the type of security on which they are paid; common equity dividends tend to fluctuate based on a company's current profitability, while preferred share dividends are generally tied to interest rates. Because they are considered higher risk investments than bonds, the returns on preferred shares tend to float at a higher rate than Certificates of Deposit or most types of bonds, with the possible exception of junk bonds.

Capital Gains

Capital gains represent the appreciation of the price of a security or investment from the time it was purchased. These gains can be long-term or short-term, depending on whether the instrument sold has been held for more than one year. Stocks and fixed income securities may experience gains (or losses). However, while fixed income securities can appreciate in prices on the secondary market, they are primarily designed to pay current interest or dividends while equities and real estate provide the bulk of their reward to investors in the form of capital gains.

Historically, gains in equities and real estate are the only returns on investments that have outpaced inflation over time, which is one of their main advantages. Of course, markets move in two directions, and any security or investment that can post a gain can also result in a loss. Stocks go up and down with all markets as well as with corporate performance.

Tax Benefits

Some types of investments generate tax-advantaged income of various types. Direct interests in oil and gas leases generate income that can be exempt from tax of 15% due to the depletion deduction. Limited partnerships, which typically invest in real estate or oil and gas, can go through passive income, which is income generated by partnership activities for investors not actively involved in the management. Passive income can be amortized with passive losses, which are generally expenses associated with the operation of the partnership's income-generating activities.

Total Return

Of course, many types of investments offer more than one type of return on investment. Common shares can provide both dividends and capital gains. Fixed income securities may also provide capital gains in addition to interest or dividend income, and partnerships may provide one or all of the above forms of income on a tax-efficient basis. Total return is calculated by adding capital gains (or subtracting capital losses) from dividends or interest income and considering any tax savings.

In Conclusion

Different types of investments show different types of returns. Some pay income in the form of interest or dividends, while others offer potential for capital appreciation. Still others offer tax benefits in addition to current income or capital gains. All these factors together make up the total return on an investment.

Becoming a Confident Investor Requires Skills, not Secrets

There is no magic secret. Becoming a financial investor takes time and dedication. But acquiring professional-level investment skills could help you take control of your financial future. If you are ready to work and learn, we can show you how you can make the right choices in any market, whether it is up, down, or flat.