There are 3 types of profits available to investors. Aim for some of each
when building a portfolio.
1. Capital gains
This is what most people think of when they imagine the benefits of investing. A capital gain is when you sell an asset for a price above what you paid. Stocks can produce capital gains, as can houses and other things. Remember: you have to sell an asset to produce a capital gain. Until you sell, you’re strictly making paper gains and losses.
Capital gains are especially attractive in non-registered accounts because they’re subject to a 50% inclusion rate. In other words, half your gain must be added to your taxable income and the other half is tax free.
Governments or companies that issue bonds, and banks that sell guaranteed investment certificates, are essentially borrowers. As such, they must pay interest to the investors who lend them money and then return their principal after a set period of years.
Investors have been big on bonds and guaranteed investment certificates (GICs) in recent years because they’re safer than stocks. Only rare, catastrophic events prevent the payment of interest and the repayment of principal on maturity. This level of security explains why the returns on interest-paying investments are historically lower than those offered by the stock market. More risk gives you the potential for higher returns, as well as higher losses.
The taxman loves interest income. Interest is taxed as regular income in non-registered accounts, which is why it’s best to keep bonds and GICs in a registered retirement savings plan or a tax-free savings account.
Well-run companies make enough money to keep building their businesses and to hand some cash to investors each quarter in the form of a dividend. While stocks can rise and then fall in price, dividends are permanent. You can either have them paid right into your account, or you can use them to purchase new shares through what’s known as a dividend reinvestment plan (DRIP).
Dividends account for a significant portion of the returns you’ll get by owning stocks over the long term. Right now, the dividends paid by the companies in the S&P/TSX Composite Index offer a yield of 3%. In other words, if you duplicated the holdings of the index, the dividends you received would give you a return on your investment of 3%. If the index rose 7% in the year ahead, you would add the 3% dividend yield to get a total return of 10%.
A quick word about taxes: the dividend tax credit means a dividend received outside a registered account is taxed much more favourably than interest paid from a bond or a GIC.