Types of Investments: Stocks

This article is a continuation of the one on bonds recently published on the blog. Initially, I had combined these two articles into a single publication. However, I received numerous comments from my readers suggesting that my articles are too lengthy. As my readers are the benchmark for this blog, I decided to reconsider and split the original article into several modules. Today’s article serves as the second module, with the remaining modules to follow in due course.

Definition of Stocks

Stocks, also known as shares or equities, represent a fundamental component of an investment portfolio. These securities confer partial ownership in a company, offering investors a stake in its financial performance. 

The value of stocks is inherently variable, subject to fluctuations that not only affect the individual investor’s holdings but also have broader implications for overall market activity.

When an investor acquires stocks, they are purchasing a portion of the issuing company, thereby gaining potential access to its profits and, in some cases, decision-making processes. 

Stocks are typically classified into two main categories: common and preferred.

I. Common Stocks

The majority of stocks traded in the market are common stocks. Common stocks provide investors with the potential for capital appreciation through rising share prices and the possibility of increasing dividends. However, the prices of common stocks are typically more volatile than those of preferred stocks.

Holders of common stock generally have the following entitlements:

1. Dividend Payments: While common shareholders may receive dividend payments, these are neither guaranteed nor fixed in amount.
2. Voting Rights: Common shareholders typically have the right to vote at shareholder meetings, usually receiving one vote per share. This voting privilege allows them to elect company directors and influence other corporate decisions either at the annual shareholder meeting or by submitting a proxy vote online or by mail. This right reflects the higher level of risk assumed with common shares.
3. Claim on Assets: In the event of the company’s bankruptcy and liquidation, common shareholders have a residual claim on the company’s assets. However, they are last in line to be paid, following tax authorities, employees, creditors, and preferred shareholders.

II. Preferred Stocks

Preferred stock provides investors with a stable source of income through fixed dividend payments, along with the potential for capital appreciation as share prices rise. The price stability of preferred stock generally exceeds that of common stock, making it a less volatile investment option. Additionally, preferred stock may include features such as the right to redeem shares at specific times or the ability to convert shares into common stock at a predetermined price, often referred to as convertible preferred shares.

However, preferred stock typically does not carry voting rights. Preferred shareholders are generally entitled to the following benefits:

1. Fixed Dividend Payments: Preferred shareholders receive dividends at a fixed rate, regardless of the company’s performance. These dividends are paid out before any dividends are distributed to common shareholders. If the company is unable to pay the preferred dividend in a given year, the unpaid amount may be carried forward to future years.
2. Priority in Asset Claims: In the event of bankruptcy and liquidation, preferred shareholders have a higher claim on the company’s assets than common shareholders, ensuring they are compensated first.

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III. Stock Volatility

Fluctuations in the stock market are a normal occurrence, driven by a complex interplay of economic conditions and human behavior. The prospect of capital appreciation is what compels investors to engage in the market.

When a stock experiences rapid and significant price changes, it is classified as more volatile. This heightened volatility increases the associated risk, as it may result in substantial losses if an investor is compelled to sell the stock on short notice to liquidate their holdings.

IV. Managing Stock Volatility

While it’s difficult to predict market volatility in investing, there are ways you can mitigate it.

A. Diversified Stock Portfolio

You can potentially mitigate the fluctuations in your stock portfolio’s overall value by diversifying your holdings across companies with varying characteristics.

Before selecting individual stocks or constructing a portfolio, it is essential to evaluate how these investments align with your existing assets, overall financial objectives, and risk tolerance.

B. Invest for the Long Term

The stock market is inherently subject to short-term volatility, including periods of market downturns. However, historically, it has demonstrated strong long-term performance. If you invest in stocks with funds that you may need in the near future, you risk being compelled to sell during a market decline, potentially realizing a loss.

C. Don’t Try to Beat the Market

Attempting to time the market is inherently risky. Stocks are designed to be long-term investments, characterized by numerous short-term price fluctuations. Engaging in frequent trading in an effort to ‘beat the market’ can lead to increased transaction costs, ultimately diminishing your returns. 

Rather than reacting to short-term market movements, it is more prudent to remain focused on your long-term financial objectives. Establish a disciplined approach by scheduling regular reviews of your portfolio, perhaps annually or semi-annually, in consultation with a financial advisor. This strategy allows you to make informed adjustments that align with your overarching goals, ensuring that your investment strategy remains on track.

D. Get Advice from Financial Advisor

Investing without a clear understanding of how the stock market operates, the factors that drive stock price fluctuations, or the mechanics of a particular investment or strategy inherently carries significant risk. By enhancing your knowledge, you can effectively mitigate this risk. 

If you are uncertain about your level of expertise, consulting a financial advisor can provide valuable guidance in selecting stocks and other investments that align with your financial goals and risk tolerance.

V. Risks of Investing in Stocks

When investing in stocks, it is important to recognize that you could potentially lose your entire investment— or, in certain circumstances, even more than your initial investment. Prior to purchasing any stock, it is crucial to thoroughly understand the associated risks and carefully assess whether these risks align with your risk tolerance.

VI. Make Money with Investing in Stocks

The value of a stock can fluctuate significantly, with frequent changes in price. As an investor, if you sell a stock for a higher price than your purchase price, you will realize a capital gain. Conversely, selling a stock for less than its purchase price results in a capital loss.

Additionally, investors can generate income from stocks through dividends. A dividend is a distribution of a company’s profits to its shareholders. The amount received typically depends on the number of shares held, the class of shares, and the duration for which the shares were owned.

VII. Stock Earnings and Taxes

The way your stock earnings are taxed depends on whether they are held in a registered plan or in a non-registered investing account.

A. Investments held inside a registered plan

Registered plans provide some tax advantages. For instance, when stocks are held within an Registered Retirement Savings Plan (RRSP), Registered Education Savings Plan (RESP), or Registered Retirement Income Fund (RRIF), the earnings generated are not subject to tax while the funds remain within the plan. However, withdrawals from these accounts are fully taxable as income. In contrast, a Tax-Free Savings Account (TFSA) offers the benefit of tax-free growth on investments held within the account, and withdrawals are also not subject to taxation.

B. Investments held outside a registered plan

Income derived from stocks held outside of registered accounts is subject to taxation. Dividends and capital gains are taxed differently, which impacts your overall investment return:

• Dividends: These are taxable in the year they are received, regardless of whether they are paid out in cash or reinvested. For dividends from Canadian companies, you may qualify for the dividend tax credit, which can reduce your taxable amount.
• Capital Gains: Tax is applied to any capital gains realized when you sell a stock for more than its purchase price. You are taxed on only 50% of the capital gains realized in a given year.

Compared to interest income, both dividends and capital gains from investments outside of registered plans benefit from preferential tax treatment.