The Stock Market
for Beginners

Introduction

There are a great many investments on the market these days -- DRIPs, spiders, preferreds, ADRs, ETFs, convertibles, etc, etc. And the list keeps growing. But you can begin your investment career by ignoring them.

There are only three types of investment you need to consider. Every security, from debentures to bank savings accounts to stocks, fit into one of the three main investment classes: Cash, Equity/Derivatives and Debt . When you understand the basic characteristics of each investment class, you won’t have to waste any time pondering whether a new investment “product” is right for you.

Being able to identify and understand the different investments on the market will give you the comfort and confidence needed to make smart investment decisions. Every security can be defined by a common set of characteristics.

Does the security generate income now or is it primarily aimed at producing capital gains? Some investments, like dividend paying stocks or income trusts, will do both.

Is the investment liquid – that is, can it be bought or sold at any time -- or is it a long-term holding with penalties charged for early redemption?

These are the kinds of questions you need to ask when considering any kind of investment — including those that haven’t been invented yet!

Understanding the three basic types of investments means that you will always be able to make a reasoned choice, regardless of whether the investment being considered is an old standby or a brand new type of security that has just come to market. Once you know the investment “class,” you will be able to make sound assumptions about risks and rewards and the advantages and disadvantages of every investment you see.

The Stock Market
for Beginners Part 1

The Three Primary Asset Classes

Let’s take a quick look at each of the investment classes and their defining characteristics.

I. Cash

Cash and cash equivalents are characterized by a high degree of liquidity, flexibility, short term-to-maturities, and modest returns. The number one objective of this asset class is to put cash to work immediately. Because these securities are so liquid, many investors use them as a “parking” place for extra cash. A cash security such as a money market fund can come in handy when you’re in the process of making a long-term investment decision. By parking the cash in a money market fund, you’re at least able to earn a modest rate of return until you make a decision.

Other investors use cash securities to store money away for emergencies. Think about it. What if your house suddenly needed a major repair or your car broke down? Where would you get the cash to pay for this kind of expense? Selling a good stock or bond, or incurring a penalty by redeeming a GIC early is not an appealing alternative!

Cash investments are directly affected by swings in interest rates and all distributions are treated as interest income — which means that any returns are fully taxable in your hands at your highest marginal rate.

II. Debt

Fixed-income or debt-based instruments are characterized by steady income, flexibility and guaranteed principal if you hold them until maturity. All debt instruments owe their origin to the time-honoured notion of “promise to pay,” sometimes called IOU. Most (but not necessarily all) debt instruments are “backed” by something — called “security.”

A company bond, for example, is backed by the assets of the company. If the company gets into trouble, the assets can and will be sold to pay back bondholders. (Security is also given by preference — for example, rights to unpaid dividends due to the common shareholders come after those of the bondholders — which is one reason that common shares, even common shares with dividends, are considered a higher risk “equity” investment and not a debt investment.) Another class of security, debentures, differ from bonds in that they are not backed by the firm’s physical assets, but by the depth of its capital resources.

The predictable income derived from fixed-income securities such as bonds allows investors to budget for monthly expenses with confidence. Fixed-income securities are choice investments for those who need to live off their investment income. In addition, investors can receive competitive yields on their principal with the assurance that they will be repaid their original investment upon maturity. Distributions on fixed-income investments are usually paid in the form of interest, which means the income earned is fully taxable.

Remember, the debt is theirs, not yours. You are lending them money and they are paying you the principal and interest on the loan. This cannot entirely protect you against default, but if anything does go wrong, you stand high on the list of creditors (although not as high as the bank, of course). Bondholders come before the government, debenture holders and common shareholders, in that order.

NOTE: Debt-backed securities have acquired something of a bad reputation since the credit crisis that began with the implosion of subprime mortgages in the U.S. in 2007. But the various exotic collateralized debt obligations (CDOs) associated with the crisis – cobbled together out of high-risk mortgages, credit card debt, automobile loans and the like – were not products sold to individual investors on the open market. Created by financial institutions, they were passed on to institutional investors and hedge funds for the most part. When you invest in a debt-based security it is in the form of a traditional, well-defined security such as a company or government bond or debenture. This also includes legitimate mortgage-backed securities that have no relation to the subprime “junk” that has justly earned such a bad reputation.

III. Equity/Derivatives

The equity asset class is characterized by capital growth, higher risk, and better performance over the long term than any other asset class.

Because this class offers potentially higher reward — albeit with potentially higher risk — it receives the greatest attention from investors. That also makes it the most lucrative investment for dealers, brokers, advisors etc. There are thousands of “variations” on equity investments, with more being “invented” everyday.

The hallmark of an equity investment can be summed up in one word — “unlimited.” Unlimited gain. Unlimited risk. Unlimited volatility. With most equity investments, you literally have no ceiling on how much you can make — or how much of your original investment you can lose. Logically of course, the most of your original investment that you can lose is 100 per cent — and this unfortunately proves true for many equity investments.

However, with one class of equities called derivatives, there is no such cap on your losses. “Short selling” or “futures trading,” for example, can generate catastrophic losses equal to many times your original investment.

Equity investments generate growth in your portfolio and help you build a solid retirement nest egg. Moreover, the capital gains triggered by equities are taxed more favorably than other sorts of investments, unless you are considered to be a professional investor or day-trader. In that case, the Canada Revenue Agency will tax your profits without regard to the risks you incurred to earn them.

Click here for The Stock Market for Beginners Part 2.