If you’re new to stocks, this is the place to start learning about them! Provided here are excerpts from the book Loonie to Toonie. These basics are essential to helping you understand what you need to know about stocks and exchange-traded funds!
ASSET CLASS: EQUITIES
Asset: Anything that has value, monetary worth, or the ability to create wealth.
Asset Class: A general grouping of investments according to similar money-generating attributes, time duration, risk levels, rules, and operations in the financial market.
Average: Price level of a select group of stocks that has been averaged out to give investors an idea of dominant trends in certain areas of the stock market.
Dividend: Regular payments made to shareholders that are distributed from a company’s earnings.
Security: A general term referring to a financial asset such as a stock or a bond that certifies ownership to the investor; a security is an investment that can usually be traded in the financial markets.
Share: Partial ownership of a company.
Stock: A security investment that gives you ownership in a company when you buy its shares.
Stock Exchange, Stock Market Exchange: A marketplace where stocks are bought and sold; nowadays, stock market exchange activities occur electronically online.
Stock Market Index: A selected group of major stocks across different sectors – performances of these stocks are measured to give investors an idea of the dominant trend in the stock market.
To have equity is to have ownership or partial ownership of something. When you buy a company’s stock, you’re buying shares or units of ownership in that company. The company’s value lies in its ability and potential to generate profits in order to expand and grow. When this happens, you anticipate the price of its stock to go up. Many factors will affect the price of a company’s stock, such as its quarterly announcement of the company earnings, news of a merger, a big lawsuit, a product recall, employees on strike, or rumours of a company buy-out. Whatever the reason, the price changes according to the demand of buyers. When demand dries up, some will sell their shares to collect profits or to reduce exposure to falling prices. The price drops until it hits a price level that investors think is good value for the stock, and from there, investors start buying up shares.
The term “equities” refers to companies that trade in the stock market exchange where their stocks are bought and sold by retail and institutional investors. There are stock markets all over the world in most countries. Each stock market exchange has the stocks of different companies which are permitted to sell their stock there. Some countries have more than one stock exchange. In Canada, our largest stock exchange is the Toronto Stock Exchange (TSX). For most exchanges, orders are now done electronically. Anyone with a computer may watch the prices of stocks fluctuate and choose to buy or sell with the click of a button through an online brokerage trading account. When you have one, the staff can assist you in buying and selling stocks from the stock exchanges.
You may have heard of the S&P 500, the Dow Jones Industrial Average, or Canada’s S&P/TSX Composite Index. These are not to be mistaken with stock exchanges. Stock market indexes and averages are analytical tools that measure the performances of a select group of stocks to give an idea of the overall trend in a particular market (such as the U.S. market) or sector (such as retail). It’s good practice to compare the performances of your stocks to the relevant indexes and averages. You want them to be about the same. However, if your stocks are underperforming, you will need to discuss new strategies with your advisor.
Despite the higher risks in equities, the capital market is generally optimistic, so you can expect most major stocks to go up in the long run. When starting out, go conservative with defensive sector stocks or blue chip stocks that pay dividends. When you can afford more, diversify your equity portfolio with stocks from different sectors to hedge against tough times and to promote portfolio growth when times are good. You can expect that some of your stocks will be weaker performers than others – this means you’ll have to rebalance your stock holdings from time to time. You might sell some or all of your shares for various reasons such as you need the money; you want to bank some of the profits; the company is in financial trouble; interest rates have increased and therefore you anticipate a turn in the economy; or you’ve aged and it’s time to rebalance the assets in your investment portfolio.
Growth in your portfolio is important, so you should have around three-quarters of your money in equities. Not only are equities taxed favourably, but the growth potential in equities exceeds the predictable returns of cash and fixed-income investments. As you age, portfolio growth is still important, but you should preserve more of your money and put less of it at risk. Reduce your portfolio’s equities to half in your 50s. In your 60s, you should hold 30% to 40% in equities. Incrementally bring this percentage down as you get older so that fixed-income is the most dominant asset class in your portfolio. Remember, these are just recommended asset proportions. You should customize your own portfolio with the help of a financial advisor.
Broker: An agent or company whose services involve providing clients with a selection of certain products; brokers are paid a commission fee once a client makes a purchase or a sale through them.
Brokerage, Brokerage Firm: A financial institution that provides its clients with a number of securities to choose from, either from its own inventory or from what is available in the markets; it charges commissions to clients for facilitating transactions.
Capital Gain: Net profit made from selling an asset at a higher price.
Capital Loss: Net loss resulting from selling an asset at a lower price.
Commission Fee: The sales charge that goes to an advisor, broker, or firm who assists a client in the purchase or sale of a product.
Dividend Reinvestment Plan, DRIP: A plan that gives you the option of reinvesting your dividend earnings for more stock shares instead of receiving money payments.
Dividend Tax Credit: The tax credit you are granted when you receive dividend payments from owning shares of a Canadian corporation; this credit significantly lowers your taxation on dividend income.
Dividend Yield: The dividend’s annual rate of return on your investment based on the price of the stock; the yield will change as the price of the stock fluctuates.
Fixed-Income Securities: Securities that produce regular fixed payments to the investor in the form of interest or dividends.
Preferred Shares, Preferreds: A type of stock share that offers fixed dividend payments in place of voting privileges; could be considered a fixed-income investment because of the regular payments.
Price-to-Earnings Ratio, P/E ratio: A ratio that tells you the value of a stock’s share price relative to what the company earns over a year.
Publicly Traded Company: A company that issues shares of ownership to be bought and sold among the public in the stock exchanges.
Yield: The financial return on the income generated by an investment.
Stocks are a major component of the equity asset class. When you invest in stocks, you make money two ways by selling your shares at a price higher than what you paid and from receiving dividend payments. Stocks hold higher risk than cash and fixed-income assets because there are no guarantees to protect your principal – you can lose a little or a lot, depending on how much less you sell your stock for. Regardless of this, there is no limit to how much you can profit from a stock. Stocks are very liquid and have no maturity dates. You can hold your stocks for one day or for many years. When buying stocks, you should be familiar with the concepts of the share price, dividend, dividend yield, the type of share, and the price-to-earnings ratio.
A publicly traded company sells its shares of ownership to the public through the stock exchange. There isn’t a minimum amount to invest in stocks, but the price of a stock will affect how many shares you can afford to buy. You can own one share or 10,000 shares in a company and you’re a shareholder either way.
If you bought 100 shares of a stock for $70 per share, you invested $7000. Let’s say the share price goes up to $95.00. It has increased by $25 and now you want to sell them. With $25 x 100 shares = $2,500 in profits, you wind up with $9,500. If the price goes in the opposite direction and drops down to $57.50, your share price will be down by $12.50. Selling your stock when it’s down by negative $12.50 x 100 shares is $1,250 in losses, and you finish with $5,750 in your account.
Dividend and Dividend Yield
A company has the option of paying dividends to shareholders as a way of sharing its earnings. If you own a number of stocks in your portfolio, most of them should pay dividends. In that way you can still make money, even if the market is weak and your stocks’ prices might be down. When you look up a stock’s information, you will see whether or not there’s a dividend price. If there is, that is the price it will pay annually for each share you own.
You’ll also find the dividend yield, which is the annual rate of return on your dividend income relative to the price of the stock. A higher dividend yield means a better return on your investment and better value for the stock’s price. You can compare dividend yields when you’re choosing between similar companies offering similar dividend amounts, but keep in mind that the yield changes as the stock price changes.
Your stock might be eligible for the dividend reinvestment plan (DRIP) in which you can have your dividend earnings reinvested to buy more shares. If you prefer to accumulate stock without paying additional commission, then speak to your broker about this option.
Types of Shares
The two main types of stock shares are common shares and preferred shares, or ‘preferreds’ for short. Normally when you look up a stock, the information that automatically appears is based on its common shares because common shares are traded more often than preferreds. Owners of common shares have the right to vote on company policies and elect a company’s board of directors. Preferred shareholders don’t typically have voting rights; instead, they are paid fixed dividends on a fixed schedule. Dividends aren’t always guaranteed, but preferred shareholders are given prioritized payment before common shareholders. You could classify preferred shares as a fixed-income investment because the regular dividend payments pay like bond coupons.
The price-to-earnings ratio, or P/E ratio, is often posted when you look up a stock as it tells a bigger story behind the stock price. This ratio is a measure that tells you whether people are paying a lot or very little in share price relative to the company’s earnings. This is useful when comparing stocks within the same sector. A lower P/E ratio indicates a good bargain in share price and stable earnings, but it could also signify that investors aren’t willing to pay more for the stock. A higher P/E ratio means that people are paying a high share price for what the company earns, but this high share price is likely because they’re optimistic about the company’s potential for further growth. You can always consult with your investment advisor to help you analyze such data.
You will need an online trading account through your bank or brokerage firm, and as a client you should take advantage of the online tools available for education and analysis. Commission fees are charged per transaction and they vary depending on where you invest. Discount brokerages offer the lowest commission fee rates.
Selling your shares results in favourable taxation as you have either a capital gain or a capital loss. Once you subtract applicable trading costs and any capital losses from your capital gains, only half of this amount is taxable.
I’ve mentioned before that dividends are a form of investment income. Tax-wise income from dividends is treated differently than capital gains and interest income. The taxation for dividends involves a complex calculation, but they are still taxed favourably. If you receive dividends from a Canadian corporation, you’re entitled to receive a dividend tax credit – this tax credit lowers what you pay on your dividend’s taxes by a significant amount.
If you’ve nearly maxed out the contribution room in your registered accounts, then it’s okay to hold stocks in a non-registered investment account. This is acceptable because of the preferential taxation on equities. Just keep in mind that you will need to report your capital gains or losses when you sell and any dividend income earned annually – even if it’s within a DRIP option – for your taxes. Seek assistance from a tax professional to ensure that you correctly report your investment earnings for your taxes. If you hold your equities in a registered account, then you do not need to report this information.
Distribution Reinvestment Plan, DRIP: An option that allows investors to have their fund’s distribution payments reinvested to buy more fund units or shares.
Distributions: Money generated from the assets held in a fund distributed to its investors.
Diversify: Investing across various asset classes to maximize growth and minimize risk.
Emerging Market: A foreign economy experiencing a more recent surge of economic progress and increase in participation among the larger markets – it has its own stock market as well.
Exchange-Traded Fund, ETF: An investment fund that trades on the stock exchange and is made up of many stocks designed to follow a stock index’s performance.
Fund Manager: A financial professional (or team) who selects and manages the assets in a portfolio of an investment fund to ensure that the performance of the portfolio is in line with the fund’s objectives.
Management Expense Ratio, MER: A fund’s annual expenses (consisting of the management fee and operating fees) which work out to be a percentage of the fund’s assets.
Management Fees: The fees paid to those managing the assets in an investment fund.
Sector: A section of the economy that consists of businesses, companies, and industries that produce similar goods and services.
Ticker Symbol: The abbreviated letter symbol(s) assigned to a stock that trades on a stock exchange.
Withholding Tax: Tax on your income or investments that is withheld by your employer or financial institution and paid to the government.
The exchange-traded fund, or ETF, is a unique type of investment fund that trades the same way stocks do. The ETF is a fund made up of many stocks – and sometimes additional securities and assets. An ETF is designed to follow a particular stock market index, average, or sector index. Just like regular stocks, ETFs bring in investors by issuing shares which are bought and traded in the stock exchanges. ETFs are also very liquid – you may hold them for very short or very long time periods. When investing in ETFs, you should know about the following concepts: distributions, ETF type, the management fee, and the management expense ratio.
You make money from ETFs when you sell your shares at a higher price. Also, you receive distributions that come from the assets held in the ETF portfolio. Distributions occur when stocks and assets in the ETF portfolio are sold for a profit, when dividends are paid from the portfolio’s stocks, or when interest is paid from the portfolio’s bonds or T-bills. When you look up an ETF, it’ll list the distribution amount that is paid per share or unit as well as the frequency of payments. If your ETF is eligible, you could sign up for a distribution reinvestment plan (also called a DRIP) so that the earnings will be reinvested to buy new shares at no extra cost.
Most ETFs you will encounter are tracking an index. An ETF will mimic the index performance as closely as possible by owning the same stocks with similar proportions as those in the index. This means that if you have shares in a stock market index ETF, it will go up and down as the market goes up or down. The ETF is a financial product that offers affordability, convenience, and market performance. It can be very difficult to pick the right stocks that will outperform the market; so many investors just buy an ETF stock for the particular market or industry in which they have an interest in investing.
An example of an ETF is iShares Core S&P/TSX Capped Composite Index ETF which trades on the Toronto Stock Exchange under the ticker symbol XIC. This ETF holds shares of the same 240 stocks measured in the S&P/TSX Capped Composite Index; this particular index tracks the stocks of the largest companies that trade in the TSX. At the time of writing, the share price is $19.50 per share, which is a lot cheaper than buying shares of 240 individual stocks and a lot easier to manage!
You’ll often encounter a few different ETFs following the very same index, only they’ll have different ticker symbols and different share prices because they are ETFs which are created and managed by different investment companies. With ETFs and stocks, there isn’t a minimum amount to invest; you may buy as many shares as you can afford. Feel free to compare prices between similar ETFs.
Types of ETFs
ETFs have grown considerably popular and are available with varieties that do more than just track stock indexes. You could invest in any of the asset classes in any sector through ETFs alone. The general risk of investing in ETFs is similar to regular stocks as they’re all affected by changes in the stock market; however, not all ETFs carry the same degree of risk. ETFs carry varying risk levels depending on the type of ETF and the assets they hold. In diversifying, you could reduce the risk that typically comes with equities by buying shares of a fixed-income ETF or a dividend ETF. You could also invest more aggressively in the shorter term. If you see that a particular sector is leading the market, for example the technology sector, then you could buy shares of a tech sector ETF.
Here are a few examples of the diversity found among ETF types:
- Sector ETFs – Financial, technology, housing, pharmaceuticals, utilities, energy, retail, real estate, and healthcare;
- Commodity ETFs – Gold, silver, crude oil, natural gas, cotton, corn, cocoa, and coffee;
- Fixed-Income ETFs – Bonds, T-bills, and preferred shares;
- Equity Income ETFs – Dividends and income trusts; and
- International ETFs – Countries and emerging markets.
Management Fee and Management Expense Ratio
You obtain ETFs the same way through banks and brokerages as you would for stocks, and the commissions to buy and sell ETFs cost the same as stocks. Unlike regular stocks, however, ETFs have additional fees. The management fee is paid to those managing the fund, which can vary depending on how actively managed the fund is. The management expense ratio (MER) calculates the annual expenses that cover both the management fee and the expenses for operating the fund. The MER is a percentage of the fund’s assets. You aren’t charged the MER directly, but it’s a small percentage that gets deducted from the fund’s assets. A higher MER percentage will mean a lower return on your investment, so keep this in mind when you’re looking at similar ETFs. You can find these fees on the ETF’s informational fact sheet when you do your research.
Selling shares of an ETF stock works the same way as regular stocks in which the result is a capital gain or loss. Whether or not your ETF is setup in a DRIP, annual earnings from distributions are taxed according to income type as capital gains, dividends, or interest income. Be aware if your ETF holds some foreign assets because all foreign distributions will be fully taxable as income and may be subject to withholding tax. Because of the varied taxation on ETF distributions, it is best if you invested in a registered account. Speak to your investment advisor about which registered accounts are most suitable for your ETF choice.
You may hold Canadian equity ETFs in a non-registered account because of the favourable taxation on capital gains and the dividend tax credits. Keep in mind that if you invest in a non-registered account, there is more work involved in reporting your ETF investment earnings for your taxes. You should do this with the guidance of a tax professional.