Equities, more commonly referred to as “stocks” or “shares,” are one of the main investment asset classes available to investors. Shares are issued by companies when they want to raise money to finance their business activities.
When you purchase equity (share) in a company, it infers that you now hold an ownership interest in the company (part-owner), and have a claim on some of its profits/assets in the form of dividends. You may also be eligible to vote at shareholder meetings. When you sell your equity in the company, it may be for more or less than what you paid for it, resulting in a capital gain or loss.
Of the main investment assets i.e. cash deposits, equities, and fixed-income securities, equities are considered to be the riskiest and have historically produced the highest return to investors over the long term.
Types of Equities
Equities can be categorized into two main types:
Common Shares: These are the most common types of shares held by investors. When you buy a common share, you become a part-owner of the business. This gives you voting rights on matters relating to the company e.g. election of the board of directors.
As a shareholder, you also have a claim on the company’s assets and profits (dividends). Dividends are however not guaranteed, and if the company falls on hard times, bondholders, preferred shareholders and other creditors get paid first.
Preferred Shares: Preferred shareholders own shares that have a greater claim to profits/assets and they are paid a fixed dividend amount per share. If the company goes bankrupt, preferred shareholders get paid before “common” shareholders. However, preferred shares generally do not come with voting rights.
Preferred shares are often referred to as hybrid securities because they have characteristics of both equities and bonds. Types of preferred shares include perpetuals, retractables/convertible, rate resets, and floating rate.
Equities can also be categorized based on the company issuing it, or what types of company stocks are held by an equity fund:
- Company ownership: private or public
- Type of company: blue-chip, income, growth, defensive, value, cyclical
- Market capitalization: large-cap, middle-cap, and small-capitalization shares
Returns on Equities
When investors assess the strength of a company and the attractiveness of its stock, some of the performance measures they use include the dividend payout ratio and dividend yield. The dividend payout ratio refers to how much of the company’s profit is paid out as dividends to shareholders, while the dividend yield measures the dividend as a percentage of the stock’s current price.
Dividends may be paid out on a monthly, quarterly, semi-annual, or annual basis. A company may decide not to pay out dividends, either because it is in financial trouble, or it wants to reinvest the funds into growing the company.
A shareholder can also make money from stocks by selling them when the price goes up. When the price you sell a stock is higher than what you paid for it, you have a capital gain. When the reverse is the case, you incur a capital loss.
Equities and Taxation
If your stocks are held within a non-registered account, they are taxed as follows:
- Capital Gains: 50% of capital gains are included in your income and taxed at your marginal tax rate. Capital losses can be carried back up to three years to reduce or eliminate capital gains. Capital losses can also be carried forward indefinitely.
- Dividends: Eligible dividends (e.g. dividends from Canadian companies) are grossed up and taxed. To avoid double taxation, you can claim the dividend tax credit. Dividends from foreign companies are added to your income and taxed at your marginal tax rate.
If you invest in stocks within a registered account such as RRSP and RESP, you do not pay taxes on income earned until you withdraw funds from your account. For a TFSA, no taxes are due on income earned.
Why Invest in Equities?
To invest in stocks, you can choose to buy individual stocks, or buy into a pool of stocks held in an equity mutual fund or ETF. Some of the advantages of investing in equities include:
- Capital Gains: If a company does well, its value and stock price go up, resulting in capital appreciation for the investor.
- Dividends: If you buy shares in a company that pays regular dividends, you get a predictable stream of income that can supplement other income from fixed-income/money-market securities.
- Liquidity: Stocks are usually traded on stock exchanges that are very liquid i.e. you can buy or dispose of them very easily without significantly affecting the price of the stock.
- Easy Diversification: Although stocks are riskier than the other major asset classes, you can invest in a portfolio of equities that are diversified across industries, sectors, and countries in order to lower your risks. This diversification can be easily accomplished using equity mutual funds/ETFs.
- Favourable Taxation: Only 50% of capital gains are taxed. Additionally, dividends get a preferential tax treatment compared to interest income (from bonds and GICs) that is 100% taxed at the investor’s marginal tax rate.
- Outperform Inflation: Long term returns on stocks tend to be above the inflation rate. This, an investment in stocks gives you a chance to grow your portfolio and generate real returns.
Disadvantages of Owning Equities
- Volatility: The stock market can be very volatile, fluctuating to news, rumour, investor sentiments, and company information. During economic downturns, stock prices can stay depressed for a prolonged period of time.
- Risk of Total Loss: A company may go bankrupt and leave nothing for common shareholders after bondholders and preferred shareholders have been settled. Companies may also fall on hard times, and be unable to pay dividends due to disappointing profits or losses.
- Time Consuming: It can be time-consuming to buy individual stocks and to evaluate each one for its merits as well as ensure your “basket” of stocks is adequately diversified. For a chance at success, you may also need to be knowledgeable about investing basics, including financial ratios like EPS, P/E, ROE, and understand financial statements.
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Equities – Risk vs. Return
When it comes to investing, the higher the risk, the greater the expected return. Equities (stocks/shares) are considered to be riskier than cash or fixed-income assets. Because of their increased riskiness, investors expect to get rewarded for taking on the “additional” risk, compared to investing in less-risky assets like GICs, Treasury bills, investment-grade-bonds, etc.
Between 1900 and 2015, Canadian stocks returned real returns (i.e. returns after deducting inflation) of 5.6% compared to 2.3% for bonds, and 1.5% for cash. What this means is that if you have time on your side and a long-term approach to investing, equities deserve a prominent place in your wealth-building strategy.