The Stock Market
for Beginners Part 3

Understanding the Risk/Reward Relationship

There is a trade-off between risk and return. The higher the return you’re after, the more risk you will likely have to assume.

Once you’ve determined what you want your money to do for you, you will need to consider the relationship between risk and reward. All investments have risks and rewards — even bank savings accounts! Understanding the risk/reward relationship can substantially minimize risk and keep your expectations in line with your investments.

Investment risk/reward is simply how much risk you are willing to take in order to achieve your investment goals. Generally, the higher the risk the higher the return will be on the investment. Investors put money to work to achieve a number of goals, including protection of capital, growth, income, liquidity, tax reduction and overall performance — and every one of these goals affects the risk/reward relationship and thus the nature of the investments you’ll select.

Never overestimate your appetite for risk. The stock market is notorious for going through periods of wild fluctuations, sometimes losing as much as 20 per cent in a single trading day. If you can’t take the market heat, you might consider scaling back your investments in the equity market, particularly issues that are not blue chips.

Don’t let anyone talk you into taking on more risk than you are comfortable with. After all, gambling on speculative stocks might not be worth the lost sleep. Only you can determine the level of risk that’s right for you.

Many have compared the risk/reward equation to an airplane trip where there is both the comfort of the flight to consider (risk); as well as how fast you can reach your destination (return).

Here’s an overview of how these characteristics affect this relationship and ultimately which investments you’ll choose for your portfolio:

1. Growth

If you have a high capital risk tolerance, you’re more likely to select investments that emphasize growth. Investment growth is directly linked to the risk of losing your principal investment, or capital. Common shares and equity funds are considered growth investments because the risk of losing your capital is higher than other investments, but your returns are generally higher too. You benefit from the potential for high returns, liquidity, tax reduction and protection from inflation. On the downside, you receive little or no income and no protection against the loss of capital.

2. Income

Investment income is most often tied to securities from fixed-income assets. Investors who require a steady stream of income invest in a range of fixed income instruments with varying levels of security, inflation protection and performance. Some of the most popular income-producing investments include bonds, Guaranteed Investment Certificates, Canada Savings Bonds, mortgage-backed securities and preferred stocks. The downside to income-producing investments is that in most cases they are fully taxable and offer little protection against inflation. In addition, they have historically offered lower returns than equity investments.

3. Liquidity

Often overlooked, investment liquidity is a key component of building a successful portfolio. Investment liquidity offers you the option to cash out, reinvest or otherwise change your investment strategy without incurring huge fees or losses that come from long delays in processing the transaction. Any investment that does not restrict access to the money you’ve invested is considered liquid.

Common stocks, mutual funds and some bonds offer high investment liquidity. Before selling any investment, however, you should be sure to consider current market conditions and interest rates to ensure the highest possible rate of return. The advantage of liquid investments is that they can provide a combination of income and growth, as well as tax savings and inflation protection, depending on the type of security selected. On the downside, you have no guarantee that your capital will be protected, or that it will not be eroded by inflation.

Preferred Shares

Although termed a “share,” a preferred share is typically classified as a fixed income investment because it pays regular income in the form of defined dividends. One expert has called preferreds “the lowest form of bond.”

Convertible preferreds, however, are classified as an equity investment because they offer the opportunity to exchange preferred shares for common shares, a much more exciting and potentially much more profitable situation.

Preferred shares offer a claim on income ahead of the common stockholder, hence the name. Should the company go bankrupt, preferred shareholders are paid any obligations ahead of any other creditors. And, should a dividend be suspended by the board of directors for any reason, the preferred shareholder will receive any unpaid dividends before dividends can be declared and paid to holders of common stock.

Although it will vary with the type of preferred you buy, you can set up a steady stream of income along with the potential for capital gains. Preferred shares are generally considered to be an investment with low or moderate risk and are designed primarily to provide income. The after-tax return of preferred shares is consistently higher than that you get with GICs.

A company issuing preferred shares may add features to the share to make it more appealing to potential buyers. These may include convertibility, call provisions and floating rates. But in exchange for the added security offered by the guaranteed income stream, a preferred shareholder gives up the right to vote on corporate governance issues.

Advantages of preferreds:

• Less volatile than common shares.
• Can be bought and sold on a stock exchange.
• Many different options available, allowing unique flexibility for your capital.
• They can be a good hedge against inflation.
• Highly advantageous tax treatment.

Dividends

Financial experts agree that as an investor you have two choices -- you can be an “owner” or a “loaner.”

Investors who buy bonds or debentures are loaning their money to the company or government in return for interest. Investors who purchase common shares with the expectation of capital gains are essentially buying part ownership in the company.

When you become an owner you take on the risk that you will lose your original investment. On the other hand, if you loan a business your money, you are guaranteed interest and the return of your principal sometime down the road.

With preferred shares is that your return is in dividends, but not capital gains. Dividends on common shares are paid after taxes and aren’t cumulative. This means that if a company suspends its dividend payments it has no obligation to make up the payment in the future.

The good news is that the dividends paid on common and preferred shares qualify for a tax credit. The Dividend Tax Credit — the basis of Canada’s “preferential” tax treatment of dividends — was introduced in recognition that the company paying the dividend has already paid tax on this money. By taxing it again in the investors’ hands the money would be “taxed twice.” This tax credit also gives Canadian investors an added incentive to invest in domestic companies.

The size and reliability of the dividend payment is really one of the most important factors to consider when buying a stock. There’s an old saying: “When dividends and earnings rise, share prices will ultimately follow.”

There are several more factors you need to consider when looking for a dividend stream:

1. Are dividend payments given top priority by the company? A company should be firmly committed to paying dividends consistently without interruption. The company should also increase the payments during periods of increased profitability and performance.

2. Stick to companies that include regular dividend payments in its forecast of future cash flows. Be wary of companies that seem to treat dividends as an afterthought, raising them irregularly. This means you are probably dealing with a relatively volatile company that is more likely to cut payments in the future.

3. If you’re the type of investor who depends on a regular, steady stream of investment income, invest only in companies that have a track record of never missing a payment and that aren’t likely to cut payments in the future.

4. Pay attention to dividend growth. Although past performance may not be an exact gauge of how likely a company is to pay dividends regularly in the future, it’s an excellent measure of its returns over a given period of time.

5. Take notice of dividend increases. A dividend rise is normally a sign of positive developments around the corner for the share price too. The rate of increase signifies how much you may expect a company’s future growth to be.

6. Look at a company’s dividend payout rates. The payout rate allows you to monitor the company’s dividend forecast. It is calculated by dividing the cash amount of dividends paid by the company’s net income. Canada’s banks generally have high payout ratios. For instance, despite the well-publicized troubles that afflicted banks in 2007 and 2008, Royal Bank of Canada promised to maintain a dividend payout ratio of 40 to 50 per cent of its net income.

DRIPs

When we refer to DRIPS, we’re not talking about leaky pipes. DRIP stands for Dividend Reinvestment Plan and it’s an excellent way to get the maximum return on an investment.

It also allows you to buy stock without paying brokerage fees or commissions. Rather than receiving dividends in cash payments, shareholders participating in a DRIP have their dividends automatically reinvested in additional shares of the company, at little or no cost. This is a solid strategy for investors with a small amount to invest and a long-term investment horizon. The lower cost of purchasing shares allows you to increase your holdings at a steady pace. Many companies that offer DRIPs have no sign-up fees and some may offer discounts off the share price to attract investors.

Some DRIPS also include Share Purchase Plans, which allow investors to purchase additional stock, at little cost, at specified times.

Advantages of DRIPs:

• Allows you to invest a small amount of money and increase your holdings at a steady pace.
• No brokerage fees or commissions.
• DRIPs employ the “dollar-cost averaging strategy” - when share prices are high, you receive fewer shares. When prices are low, you get more shares for your money.
• Encourages regular investment.

Disadvantages of DRIPs:

• You’ll have to pay a little extra up front to get in. You must own registered share of the company to enroll in the plan. You can buy this share, or a number of shares through a discount broker, but you’ll likely have to pay a fee for registration.
• Shares are sold at set times, whether market conditions are good or bad.
• Withdrawal amounts and frequency may be limited. Some companies will sell shares at a nominal fee, while others issue a certificate which can be sent to a broker for sale at a moderate commission fee.

Options, Puts, Calls, LEAPs

Options? Puts? Calls? The name of the game here is leverage, or investing on margin. You start off with a small stake, but eventually you either collect your profits – or cover your losses. That’s what makes these investments such a risky game. Sometimes the gamble pays off and sometimes it doesn’t.

Options have been around since the 17th century. The first option transaction on a common stock took place in 1694 in England. But it took almost 300 years until the Chicago Board Options Exchange was founded to become the first exchange in the world to list options.

An option is a security that gives you the right to buy or sell a security at a specific price for a specific period of time. There are two types of options: call options and put options. A call option gives you the right to buy shares at a fixed price for a fixed period of time, regardless of current market price. A put option is just the opposite — it gives you the right to sell shares based on the same principle.

Here’s a brief rundown on the basics of option investing:

Option leverage is created by the multiplying factor. A single call or put represents the right to buy or sell one hundred shares of common stock. Therefore, 10 calls represents the right to buy one thousand shares. The strike price is the price at which the contract can be exercised. When the stock’s price rises above the conversion price, the option is said to be “in-the-money” — the contract has intrinsic value if you want to sell. When the shares are trading below the strike price, a call option is said to be trading “out-of-the-money.” When they’re trading at the strike price they’re said to be trading “on-the-money.”

The longer the term of the option, the higher the time value, since a longer term gives the underlying shares more time to move. As soon as you buy an option, you’re on the clock.

As with any other investment, your goal is to make money -- you want to buy your option cheap and sell it at the highest possible price. The best “deals” generally are on out-of-the-money options (options where the right to buy or sell is far removed from the current trading range of the security). These are relatively inexpensive — in fact, on some out-of-the-money options, the broker’s fee is larger than the option price! Of course, the risk is higher too.

Example:

ABC is trading at $79. You are very bullish on ABC and instead of buying shares you want to buy the “right to purchase” down the road. Whether or not you ever actually purchase the shares is irrelevant — the option, or right to purchase can itself be traded on the market as if it were a security all its own— in effect, it becomes one as soon as you buy it.

The date is December 23rd. You can buy a single January option on ABC for 100 shares, expiring in mid-January at a strike price of $79 for $400 plus $50 in brokers’ fees. This means that for every dollar the market price of ABC rises above $79 in the first half of January, you will be making $100.

Of course, since the option itself costs you $400 plus that $50 commission, ABC will have to be trading at $84 or better to make the option worth selling. That’s when you start to break even, and don’t forget to include the additional $50 commission when you sell! Otherwise, you will most likely allow the option to expire “worthless” and thus turn your investment into a 100 per cent loss.

The above example was an “on-the-money” option. For that same $400 you might purchase 10 individual January options (each covering 100 shares) for ABC at a strike price of $89. Until ABC reaches $89, the options are still effectively worthless (unless other speculators who are equally bullish on ABC decide there may be some slight “time” value premium in the option).

But for every dollar above $89 shown in the market value of ABC prior to the option’s expiry, you will potentially make 10 X $100, or $1,000. If ABC is going great guns and reaches $93 by mid-January, your $450 investment will net you, before commissions, $4 x $1,000 or $4,000 less the option cost ($400) for a profit of $3,600, or a gross gain of 900 per cent in less than a month [not counting commissions and taxes).

Another type of option is called a LEAP. This acronym stands for Long-term Equity Anticipation. LEAPs are identical to standard options, except that they have a term of one or two years (standard options, the more popular of the two, trade in nine-month cycles with no more than three expiry dates outstanding at any time). LEAPs give you more time to “nursemaid” your option and see if your strategy is correct.

Many professional traders feel that a LEAP offers much better value for heavily-traded stocks and provides more downside protection. If there is an equity you feel is undervalued, and you want leverage without the time pressure of the traditional option, these are worth considering. LEAPs are currently listed on the American Stock Exchange, the Chicago Board Options Exchange, the Pacific Exchange, and the Philadelphia Stock Exchange.

Warrants

In a competitive market, companies are constantly trying to attract investors. A warrant is just one example of a “sweetener” added to stocks or bonds to make the investment more palatable to investors. A warrant is either a certificate of ownership of rights, or, most commonly, a certificate of an option to buy shares in the issuing company. This warrant allows the holder the opportunity to buy shares in a company at a stated price over a specified period of time. Warrants are usually issued in conjunction with a new issue of bonds, preferred shares or common shares.

In a sense, that means warrants are “options” that originate with the company itself. Warrants on well-traded securities can generate an after-market of their own. They will be quoted in the daily paper (or on the Internet) just as if they were securities by themselves, which, of course, they are!

It is important to be cautious when trading warrants and pay attention to the expiry dates. As with options (above) the value of a warrant declines dramatically as the expiry date rolls around.

Click here for The Stock Market for Beginners Part 4.