Understanding equities

This section provides a brief introduction to equities, including benefits of investing in equities and the risks involved:

What are equities?

Equities are pieces of a company, also known as "stocks." When you buy stocks or shares of a company, you're basically purchasing an ownership interest in that company. A company's stockholders or shareholders all have equity in the company, or own a fractional portion of the whole company. They buy the stocks because they expect to profit when the company profits. Companies issue two basic types of stock: common and preferred shares.

What are common shares?

Both public and private corporations can issue common shares. Common shareholders are the owners of a company and initially provide the equity capital to start the business.

Common share ownership in a public company offers many benefits to investors. The following are some of its main advantages:

  • Capital appreciation
  • Dividends
  • Voting privileges
  • Marketability, meaning shares can easily be bought or sold

There are also a few drawbacks to owning common shares. Although part owner of the business, common shareholders are in a relatively weak position, as senior creditors, bond holders and preferred shareholders all have prior claims on the earnings and assets of a company. While interest payments are guaranteed to bond holders, dividends are payable to shareholders at the discretion of the directors of a company.

What are preferred shares?

Preferred stock is a class of share capital that generally entitles shareholders to fixed dividends ahead of the company's common shares and to a stated dollar value per share in the event of liquidation. Typically, the preferred shareholder occupies a position between that of a company's creditors and its common shareholders. If a company's ability to pay interest and dividends suffers due to poor earnings, the preferred shareholder is better protected than common shareholders but worse off than creditors.

There are many different variations of preferred shares, including convertible, retractable, and variable-rate preferred shares. Most Canadian preferred shares are cumulative: when dividends are withheld, they accumulate in what is known as arrears. All arrears of cumulative preferred dividends must be paid before any common dividends can be distributed.

As preferred shares have characteristics of both debt and equity; they provide a link between the bond and common equity sections of a portfolio. Because there is such a wide variety of preferred shares available, they are suitable investments for most investment portfolios.

One shortcoming of preferred shares is that many are non-voting. However, after a specified number of preferred dividends are withheld, voting rights are usually assigned to preferred shareholders.

Why should I invest in equities?

No matter where you are in life, equities have an important role to play within a properly diversified portfolio. They can help with building your savings, maximizing your income and protecting your wealth:

  • Building your savings
    Historically, equities provide superior long-term returns compared to cash and fixed-income investments. However, equities typically fluctuate more in value. Because these fluctuations tend to smooth out over time, it’s important to take a long-term perspective when investing in equities. Just because a particular equity is down one year doesn’t mean it will be down in 10 years. The key is to determine when it’s a temporary setback and when it’s a more serious problem.
  • Maximizing your income
    If you’re an income-oriented investor, your portfolio probably contains a high percentage of T-bills and government bonds. However, it ’s important not to overlook the key role that equities can play in your portfolio. First, certain equities like income trusts can enhance your income. In addition, the income generated by equity investments— like dividends or capital gains—is taxed more favourably than interest income. Setting aside a certain percentage of your portfolio to equities can enhance your after-tax income.
  • Protecting your wealth
    Another reason to invest in equities is to protect your wealth. This may seem counterintuitive given that equities are not guaranteed, while fixed-income investments are. However, because fixed-income investments offer such low interest rates, they offer little protection from taxes and inflation eroding your wealth over time. Again, adding a certain percentage of equities to your portfolio, while keeping the balance in guaranteed investments, can help protect your portfolio’s value in the long run.

Are there risks involved with equities?

Yes. Equity investments vary in their risk but are generally considered higher risk than cash-type investments or bonds.

Equities offer growth of capital and dividends but you must endure the unpredictable ups and downs (risk) of the stock market. This is one of the many reasons equities are often more suitable for longer investing time horizons.

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