Chapter 3 - Investment Types

“You get out of an investment what you put into it, so the first decision you have to make is how much time you are prepared to devote to the initial task of acquiring a basic knowledge of investment.”  – James D. Slater, British investment columnist.

Today, investors have a bevy of investment types to choose from.  Each carries their own distinctive personalities, advantages, and inherent risks.  As an investor, it is wise to allocate your financial assets (i.e., your cash) across different investment types.  Placing all your cash in one investment vehicle or asset class may be risky because if that particular type of asset performs poorly you will not be in a position to watch your investment tree grow.  Likewise, you may be missing out on other opportunities where other asset classes are prospering.  It would take much too long for me to cover all the available investment types.  Nonetheless, I will cover the most popular ones, namely:

• Savings Accounts, CDs, and GICs
• Bonds
• Stocks
• Mutual Funds
• Exchange-Traded Funds (ETFs)
• American Depositary Receipts (ADRs)
• Commodities

There is money to be made in all these investment types.  In some of these, your money will grow slowly, but at a steady pace.  In others, your money may grow more quickly.  Each type has its own unique qualities and risks.  Which ones you decide to include in your investment portfolio depends on your age, your personal investment objectives (refer back to Chapter 1), your personal investment philosophy or style, and your tolerance for risk.  If you are not sure what your investment philosophy or style is at this particular point in time, don’t worry about it.  By the time you finish reading this book you will already have a good idea about how, why, and where you want to invest.  In addition, with time you will gain experience and wisdom about the investment world.  You will have triumphs but you will also make mistakes along the way.  You will learn from those mistakes.  Without further delay, let’s take a look at what’s available out there.

Let’s begin with the safest investment types.  Savings Accounts, CDs, and GICs are all good choices if you are looking for a safe investment that provides a steady payout.  The major drawback of these investment choices is that they usually offer lower returns which take the form of interest payments.  Let’s take a closer look at each.

Let’s face it, most bank accounts offer little to no interest and extract money from you at the end of each month in service charges.  In the old days, traditional banks offered decent interest rates on savings accounts.  But this is no longer the norm.  There is good news however since a new wave of online banks is emerging that offer higher interest-bearing savings accounts.  They offer higher rates primarily due to lower operating costs since they have no physical branches to run.  Everything is done online or by telephone.  One such bank that is gaining popularity in North America is ING Direct.  It is Dutch-based but operates its banks in several countries.  What is really interesting about an online bank such as ING Direct is that it offers consumers the possibility of opening up an investment savings account that offers a reasonable rate of interest (3.5% at the time this book was published) without any fees, service charges, or minimum account requirements.  It is an extremely safe way to invest as money held in each account is federally insured just as it is in traditional banks.  In Canada each account is insured for up to $100,000 by the Canada Deposit Insurance Corporation (CDIC).  In the United States accounts are also insured for $100,000 by the FederalDeposit Insurance Corporation (FDIC).

Banking transactions such as deposits and withdrawals can be done easily and quickly online.  You can add to the savings account by simply specifying your checking account information from your traditional bank.  Then you can transfer funds (at no charge) between the accounts at the push of a button.  In addition, you can ask ING Direct to automatically take a specified dollar amount from your checking account at a given frequency, say every week or month, to further fund your savings account in order to save more while earning additional interest.  The more you save, the more you earn, as the interest and principal compound over time.  It is always a good idea to keep a chunk of cash, some say between 5% and 10%, of your total investment portfolio for life’s emergencies or even to take advantage of new, more lucrative, investment opportunities.  In summary, holding a cash portion of your investment portfolio in an investment savings account makes good sense.

2. Certificates of Deposit (CDs)

Certificates of Deposits, or CDs, represent another safe means by which you can invest some of your cash.  A certificate of deposit is a certificate issued and sold by a financial institution such as a bank or a credit union that entitles the holder to receive interest.  A CD has a term (or maturity date), pays a specified rate of interest, and can be issued in any denomination.  Terms typically vary from thirty days to five years.  CDs usually pay slightly higher interest rates than do investment savings accounts described above.  Usually, the longer the term and the larger the principal or amount invested, the higher the rate the CD pays.  Like savings accounts, CDs are usually federally insured by the FDIC, but be sure to ask your financial institution whether this is the case.  The major drawback of buying a CD is that if you need to sell it before the end of its term or maturity date you will incur a penalty for early withdrawal.  Such penalties can be quite steep.  So be sure to carefully read the terms and conditions listed by the financial institution for this product.  The second significant drawback of purchasing a CD is that you may be committing your cash for a long time while only receiving a low rate of interest.  Make it a duty to compare rates for CDs across several financial institutions as they vary from one to another.  The rates offered for CDs by financial institutions can even be lower than those of investment savings accounts offered by online banks such as ING Direct.  Once more, take the time to compare rates as well as the corresponding terms and conditions.  A final note about CDs is that you can choose to have interest payments mailed to you in the form of a check or transferred to your bank account, or you can leave them in the CD account.  I recommend that you leave them in your CD account, as you will earn more interest due to the effects of compounding.

3. Guaranteed Investment Certificates (GICs)

GICs are similar in nature to CDs described above.  A Guaranteed Investment Certificate is an investment that offers a guaranteed rate of return over a fixed period of time.  They are offered by Canadian banks and trust companies. Be sure to check out GICs offered by online banks such as ING Direct as they usually tend to provide better rates than traditional banks. Terms for GICs are very similar than those of CDs.  They usually come in short-term contracts (less than one year) or long-term contracts (one to five years).  Finally, you may also incur a penalty for an early withdrawal.

Bonds

Bond Basics

A bond is both a loan and an investment.  A bond is simply a cash loan from a lender to a borrower.  The lender can be a person like you or me, a firm, or any organization that has money to lend.  Borrowers typically include governments and businesses.  They often need to borrow money to finance their activities (as discussed in the previous chapter).  Moreover, the borrower (issuer) uses the cash amount of the loan (face value) for a specific period of time (term) and promises to repay the entire loan amount (principal) when the bond matures (maturity date) along with interest payments (coupon) along the way.  Say, as an example, you have spare cash and you decide to buy a bond with a $1,000 face value, a 4% coupon rate, and a ten-year maturity.  This means that each year you would collect interest payments of $40 and at the end of the tenth year you would get back your principal, or $1,000.  I will explain all this fancy bond terminology in a minute.  For now, I want to define a bond as an investment.  Bonds are also seen as investments because they generate a steady flow of income.  This is why bonds are also known as fixed-income investments.  Bonds can be purchased directly from their issuers, through a financial institution, or through a broker.  Now it is time to get back to our bond terms.

Bond Terminology

1. Face Value

The Face Value or Par Value is the amount the issuer of the bond agrees to pay upon maturity of the loan.  In other words, it is the initial loan amount.  They call it Face Value because it is usually stated on the face of the bond.  The most common denomination or face value for bonds is $1,000.

2. Coupon or Coupon Rate

The Coupon Rate is the rate of interest that the bond pays.  Interest payments to bondholders are usually made twice a year at six month intervals.  Bonds that pay no interest are called zero-coupon bonds.

3. Maturity Date

The Maturity Date states the date on which the amount borrowed must be returned to the lender and, when interest payments end.

4. Term to Maturity

Term to Maturity represents the time that is remaining before the bond matures.  For example, a thirty-year bond issued in 2005 had a thirty-year term to maturity.  In 2020, the term to maturity for the same bond will become fifteen years.  And in 2030, the term to maturity will be five years.  And so forth.

5. Current Yield

The Current Yield is simply the return or annual income received from the bond expressed as a percentage of its cost or market price.  A simple formula can be used to calculate the yield: Yield = Coupon / Price.  For example, suppose you bought a bond at $1,000 that has a coupon rate of 6%.  The yield would be = 60 / 1,000 or 6%.  Simply plug in the coupon rate for the bond as the numerator in the formula and its cost or price as the denominator.

6. Yield to Maturity

Whereas current yield calculates the return of a bond for a shorter period, the Yield to Maturity calculates it for the remaining life of the bond.  In other words, this represents the total return (interest payments + face value) you will receive upon maturity of the bond.  Here the face value of the bond is included in the investment return and is referred to as the capital gain (or loss) portion.  Of course, if you paid $1,000 for a bond and its stated face value is $1,000, your capital gain upon sale of the bond will be zero.  So, you might ask: “Why bother calculating this portion in the investment return?”  The answer is simple.  Sometimes people will buy bonds from a current owner at a price that is higher (at a premium) or lower (at a discount) than is stated on the face value.  For instance, an investor who needs quick cash can sell her $1,000 face value 6% coupon bond for $800.  The new owner will have purchased the $1,000 face value bond at a $200 discount.  If the new bond owner holds the bond to maturity (s)he will receive a yield to maturity that is higher.  This occurs because the new yield will be higher – 7.5% (i.e., 60 / 800) instead of 6%.  And when the bond matures the new bondholder will receive $1,000 (the face value stated on the bond), despite having paid only $800 for it.  So, the yield to maturity yardstick allows investors to determine the rate of return on the investment.

7. Callable Bond

The issuer of a Callable Bond reserves the right to redeem (call) it before the maturity date.  When the bond is called or redeemed, the issuer pays back the loan amount (principal) in full to the lender and is no longer required to make interest payments.  Issuers will call back bonds when interest rates drop or when they are in possession of enough cash to repay debts.

Reading Bond Quotations

When considering investing in bonds, you really need to understand how they are priced, what interest they pay, and what yield they provide.  Bond quotations tell you just that.  Bond quotations are listed every day in the financial section of most daily newspapers as well as on financial websites.  A bond quotation typically looks like the one that appears in the table below.

Table 11 – Bond Quotation

This quotation means that a 5.00% coupon bond of the XYZ company which matures on May 1st, 2036 could be sold for $994.20 per $1,000 face value.  6.42% is the yield to maturity.  The Yield Change represents the change in yield from the previous day.

Bond Types

Various types of bonds are available to investors.  The main types are discussed below.  In addition, investors can also choose to invest in bond funds which offer a mixture of different bond types.

1. Government Bonds

Government bonds are the safest kinds of bonds since they are fully backed by the federal government.  They are the most popular type of bonds since investors enjoy their safe and stable returns.  The only downside is that government bonds usually pay lower interest than other types of bonds such as Municipal or Corporate bonds.

2. Government of Canada Bonds

The federal government is the biggest issuer of bonds in Canada.  These bonds pay a fixed level of interest on a semi-annual basis until maturity.  They are available in terms of one to thirty years.  Bonds with terms of two, five, ten, twenty, and thirty years are popular, as they are quoted on a daily basis.  Minimum investment is set at $1,000 or $5,000 with additional increments set at $1,000 but the amount can be higher depending on the financial institution.  You can also purchase Government of Canada Bonds in U.S. dollar denominations.  It is worthwhile to note that the Canadian government also fully guarantees or backs bonds issued by federal crown corporations such as the Canadian Mortgage and Housing Corporation (CMHC), the Business Development Bank of Canada (BDC), and the Export Development Corporation (EDC).

Provincial bonds are extremely similar to Government of Canada bonds except that they are backed by their respective provincial governments and they pay a slightly higher level of interest.

3. United States Treasury Bonds

U.S. Treasury Bonds, commonly referred to as Treasurys, are the most widely held bonds in North America as they are backed by Uncle Sam.  They pay a fixed level of interest income every six months until maturity.  Terms are from ten up to thirty years.  The minimum purchase is $1,000, and additional increments are also set at $1,000.

4. Savings Bonds

Savings bonds are also popular among North Americans.

Canada Savings Bonds have no fees and are cashable at any time.  Only Canadian residents can hold them.  They are available in regular interest or compound-bearing interest forms.  With the compound-bearing type, interest is added to the bond and paid when you cash it in.  Canada Savings Bonds come in two flavors: the Canada Savings Bond or CSB (S-series) and the Canada Premium Bond or CPB (P-series).  The CPB can be redeemed once a year on the anniversary of the issue and during the thirty days thereafter.  Canada Savings Bonds are non-marketable, meaning that they cannot be sold on the secondary bond market.

In the United States the Treasury Department issues Series EE and HH Savings Bonds.  EE bonds are sold at half their face value; for example, you pay $25 for a $50 bond.  Denominations for EE bonds are: $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000.  EE bonds earn interest for thirty years after they are purchased.  They pay a fixed-rate of interest.  EE bonds are an accrual type of security, meaning that interest is added to the bond monthly and is paid when you cash it in.  You may cash in the bond at any time but if you do so before the fifth year you will have to forfeit the three most recent months’ interest.  These bonds are available for purchase at almost any financial institution, through your employer’s payroll or retirement savings deduction plan, or directly via TreasuryDirect.gov.  Savings Bonds are non-marketable.  This means that they cannot be traded on the secondary bond market.  But what is really beneficial about United States Savings Bonds (unlike Canadian Savings Bonds) is that the interest earnings are exempt from state and local taxes.  However, they are not exempt from federal taxes.  But there is one exception.  If the earnings are used to finance the education of the bondholder, his or her spouse, or a dependent, then the interest earnings are exempt from federal taxes. 

Series HH bonds are acquired in exchange for matured EE bonds.  They pay interest every six months and continue to earn interest for a period of up to twenty years.  The interest rate is determined at the time of purchase and is subject to change at the end of the tenth year.  Denominations for HH bonds also range from $500 to $10,000.

5. Municipal Bonds

Municipal bonds, or munis, can be issued by state, city, or local governments.  They are not as safe as government or provincial bonds but are generally safer than corporate bonds.  Munis don’t necessarily pay high yields but to Americans they are very tax friendly.  Munis are exempt from federal, state, and local taxes.  Therefore, the net return can compensate for the lower yield.  Consequently, munis are an ideal investment for people who live with a high tax burden. 

6. Corporate Bonds

Corporate bonds are a step up on the risk scale from munis, but they make up for it in returns.  Corporate bonds represent a more lucrative fixed-income investment as they usually pay a higher coupon rate.  They pay higher interest because of the extra risk you are assuming.  You see, corporations are more susceptible or sensitive to economic downturns than governments are.  In addition, mismanagement of the company or increased global competition can be factors that affect the performance and solvency of corporations.  On occasion, they can even go bankrupt.  Even though large, established businesses seldom go bankrupt, it does happen.  That is why corporate bonds are rated by debt-rating agencies.  I will discuss the ratings of bonds in more detail in the following section.  Corporate bonds can vary tremendously.  They have different terms, variable coupon rates, and associated levels of risk.  Some are secured while others aren’t.  Some are callable while others are convertible.  Let’s attempt to demystify some of these more eccentric attributes that define the corporate bond.  Secured bonds are backed by company assets.  In other words, if the company does not have enough liquidity (i.e., cash) to pay its bondholders then it will sell off some of its assets in order to do so.  Unsecured bonds are riskier, as no assets are pledged as security.  Unsecured bonds, corporate or otherwise, are called debentures.  Now let’s take a look at four popular kinds of corporate bonds: Fixed-Rate, Callable, Zero-Coupon, and Convertibles.

7. Corporate – Fixed-rate Bonds

Fixed-rate bonds are regular bonds that pay a fixed level of interest until maturity.

8. Corporate – Callable Bonds

Callable or redeemable bonds can be called (i.e., bought back) from the issuer at any time.  Upon redemption, the issuer will buy back the bond at the call price.  The call price is usually higher than the face value of the bond, in order to compensate the bondholder.  Corporations like to issue callables because when interest rates decrease they can re-issue debt at lower-paying interest which will be more cost effective for them.  Without callables they would be stuck paying higher interest rates, perhaps for very long periods of time.

9. Corporate – Zero-Coupon Bonds

Zero-coupon bonds have a zero coupon rate.  This means that they do not render regular interest payments.  In order to attract buyers, these bonds are sold at a deep discount, meaning at a price that is well below its face value.  The investor’s profit comes from selling the bond upon maturity for its full face-value.

10. Corporate – Convertible Bonds

Convertibles or convertible bonds are quite unique because they can be converted into shares of stock in the same company.  Certain conditions will apply as to when and in which price range the bond can be converted into shares.

Bond Ratings

As mentioned before, some bonds are rated in terms of the credit worthiness of their issuer.  Although some municipal bonds are assigned ratings, it is mostly corporate bonds that are rated by debt-rating agencies.  The premise for rating bonds lies in the fact that bondholders want to know if the issuer is solvent and has the ability to pay its debts.  There are three major debt-rating agencies in the United States: Moody’s, Standard & Poors, and Fitch.  In addition, the Dominion Bond Rating Service is a Canadian organization that rates bonds.  These debt-rating agencies will look at several key issues when assigning a rating to a company or issuer.  The company’s overall financial position, level of revenues and profits, and level of debt are some of the main things that are examined.  In addition, the overall economy and related sector or industry outlook are considered.  Bonds that receive high or good ratings generally pay low interest and bonds that receive low ratings generally pay high interest.  This may sound odd but keep in mind that what is rated is not the return of the bond itself, but rather the ability of the issuer to repay the loan.  In other words, the higher the rating, the safer the investment.  Bonds are rated using a letter system where, on the top end of the scale, the best bonds are rated AAA while the worst ones are rated D, indicating that the issuer is in default or unable to pay its debts.  You can consult the meaning of each of these ratings using the online encyclopedia Wikipedia via the hyperlinks in the following link box.

By the way, government bonds or Treasurys are not rated because they are fully backed by the federal government.

Junk / High-Yield Bonds

The last type of bond is the most speculative and risky.  Junk bonds, also known as High-Yield bonds, are low-rated bonds that pay high yields but are much riskier because the companies that issue them have a less than stellar financial rating.  They are issued by startup companies or companies that are not established or stable in their respective markets.  The chance that the issuer will default on the loan is usually high. 

Tax Implications of Bonds

Since bonds typically yield smaller returns than do stocks (over the long run), it is critical for you to know how they are taxed because what really counts is the net return on your investment.  In other words, what is most important is how much of the return you get to keep after taxes.  Returns from bonds come in two forms: interest income and capital gains income.  Each form of income is taxed differently.  Without getting into the specifics or precise rates by which these types of income are taxed by Uncle Sam or the Canada Revenue Agency, suffice it to say that the interest income is taxed at the full rate (double the rate of capital gains income).  What’s worse is that you are much more likely to receive interest income from your bond investment than a capital gain.  Unless you bought the bond at a discount, your capital gain will be zero.  So what really matters is sheltering the interest income from the taxman.  The best way to do this is to purchase your bond and hold it within your retirement account such as an RRSP (for Canadians) or a 401(k) or IRA (for Americans).  By the time you withdraw any investment earnings from your retirement account it will be considered and taxed as regular income.  In other words, the interest generated from your bond investment will be taxed at a much lower rate.  You see, it doesn’t matter if your investment returns in the retirement account are in the form of interest, dividends, or capital gains; once they are withdrawn as retirement income they will simply be taxed according to your marginal rate (which will probably be lower by then anyway).  Americans enjoy a second way in which they can avoid paying income on bond returns.  Municipal bonds are tax-friendly.  Thus, they should be considered over other types of bonds as a way to earn tax-free investment income.

Stocks

A stock is a piece of ownership in a company.  Both private and public firms issue (sell) stock to investors in order to raise capital (i.e., cash) to help grow their business.  With private companies, stock is made available only to a limited number of people, whereas with public companies, better known as publicly-traded companies, stock is made available to anyone who wants to invest in the company.  For the most part, as an investor, you are more likely to purchase stock in a public corporation.  You usually buy stock in a public corporation in the form of shares.  Each share represents a unit of ownership in the company.  All shares have a common price.  The first time that a company issues shares to the public, it is by means of an Initial Public Offering (IPO).  During an IPO all shares are initially sold to an underwriter (usually a large investment firm), who then sells a portion to its preferred clients and then makes the remaining shares available for trading on a specific stock exchange.  Once the shares hit the stock exchange they can be bought or sold by anyone.

Market Capitalization

The market value of a company’s stock is determined by multiplying the number of shares outstanding (existing) by its current trading price.  For example, if a company issued one million shares and each share is currently trading at $50, then the market value of the stock is said to be worth $50 million.  In the world of stocks, market value is more commonly known as Market Capitalization.  Companies are categorized into one of three sizes (market cap) as explained in the table below.

Table 12 – Market Capitalization of Stocks

As you can see from the table above, large-cap stocks are from large companies, often multinationals, that are well established.  They have been around for a long time and have weathered many economic storms.  Thus, they are much less volatile than small or mid-caps.  Volatility refers to the sensitivity of a stock (i.e., the rising or falling of) to a number of factors.  We have talked about such factors in the previous chapter.  Although large-caps tend to appreciate more slowly in value than mid or small-cap stocks, they generally represent safer investments.  Small-cap stocks are from younger, less established and less experienced companies that are trying to break into a particular market.  They have huge profit potential as many of them are poised for tremendous growth.  But unfortunately, it can take a long time, even several years, before profits are high enough to drive up their stock price.  They are also more volatile, especially in periods of economic downturn, so they carry additional risks.  Mid-cap stocks offer somewhat of a middle-ground between large and small-caps.  Mid-caps are typically from high-growth companies that are gaining ground in their respective business markets.  They are highly innovative firms run by very good managers.  During times of economic prosperity, mid-cap stocks will outshine large-cap stocks in terms of price appreciation; consequently, mid-cap indices will rise above large-cap indices by a significant margin, representing larger gains for their investors.  The downside is that mid-cap stocks usually fall further than large-cap stocks during economic slides.  Finally, it is worth pointing out that large, mid, and small-cap stocks do not necessarily move in the same direction during a given period.  Small and mid-cap stocks tend to move (rise) before large-caps at the brink of an economic upswing.  But they also lose value more quickly than large-caps when the economy and markets begin to fumble.  It is somewhat difficult to predict when each category of stock will move up or down.  But one thing is for sure: you need to be more patient to see a progression with small and mid-cap stocks.  If you can assume more risk and are patient, they can offer higher rewards.

Types of stock

Generally speaking, there are four types of stocks that investors choose from.  They are Growth stocks, Value stocks, Dividend (or Income) stocks, and Penny stocks.  Each type has its own unique characteristics and appeal.

1. Growth Stocks

Many investors seek companies that are demonstrating consistent earnings and sales growth, usually upwards of 15% or 20% or more for the past three or four years.  Evidence of growth is apparent in the increase of the stock’s price over the last few years.  Such growth indicates that the company is growing consistently while remaining profitable.  Growth companies usually reinvest their earnings rather than distributing them to investors in the form of dividends.  The retained earnings permit the company to further expand their sales and marketing endeavors in order to increase their market share.  Growth companies are very competitive in their respective fields or industries.  They typically gain market share on their competitors.  But as with all cycles, growth (especially in domestic sales) will begin to level-off at some point.  What’s more is that when there is a downturn in the economy, growth stocks tend to perform poorly, thus carrying added risk.  Nonetheless, what investors try to do with a growth strategy is to buy the stock at the beginning of the growth phase.  And once growth becomes flatter, investors will sell the stock for a large capital gain and look for other growth opportunities. 

2. Value Stocks

Value stocks appear to be somewhat the opposite of growth stocks.  Don’t be misguided by the term value.  In this case, we don’t mean that the stock is currently valuable.  Rather, the stock is seen as a bargain because it appears to be undervalued.  In other words, investors are hunting for value at a bargain price.  For the most part, value stocks are those of solid companies; it is just that they may be experiencing cash flow problems, poor sales, or other temporary difficulties.  Despite such problems, investors see a possible comeback later.  Value stocks are considered more conservative investments than growth stocks.  At the same time, their potential for profit will be considered low.  The upside is that some value stocks do pay dividends, albeit perhaps not with the same consistency as dividend stocks.

3. Dividend (or Income) Stocks

In my opinion, good quality dividend stocks are underrated and should be considered as a serious contender for inclusion in any investment portfolio.  Dividend Stocks, also known as Income Stocks, are stocks that provide regular payouts in the form of dividends to its stockholders.  What is a dividend?  In its simplest terms, a dividend is the sharing of company profits, usually in the form of a cash payment, to stockholders.  Dividends are usually offered by well established companies such as multinationals.  These companies are usually leaders in their respective fields and have strong brands as well as consistent sales and earnings.  Dividend-paying companies like to reward their investors for their loyalty and commitment to the firm.  In reality there is no obligation for the firm to issue dividends.  It really depends on a company’s Board of Directors.  They decide whether or not to issue dividends based on a number of factors such as sales performance, stock performance, earnings, level of company debt, expansion plans, etc.  However, most dividend-paying companies pay dividends on a quarterly (every three months), semi-annual, or annual, basis.  On occasion, certain companies even issue a Special Dividendevery eight, nine, or ten years or so to reward investors for sticking with them over the long run.  These special dividends can be huge, sometimes giving seven or eight times the regular dividend amount. 

Some companies offer Dividend Reinvestment Plans (DRIPs) in which they give the option to their shareholders to reinvest dividends in additional company stock (commission-free) as opposed to receiving cash distributions.  Keep in mind, though, that a cash payment is an actual realized gain.  In other words, it is money you should take immediately.  On the other hand, if you were to reinvest in additional stock, you are giving up cash and assuming the risk of the stock declining in value.  Moreover, an unrealized gain is one in which you have not sold your investment to materialize a cash profit.  Until you cash in, it’s only a profit on paper!  It is really up to you to decide what is best.  Personally, I think it is a good idea to use the cash and diversify into other investments.

One thing you should examine when evaluating income or dividend stocks is to see whether the company has been increasing its dividend per share every year.  This is important because without increases the same dividend may actually shrink in value over time, due to inflation.  So be sure to look at the dividend payout history over time.  You can usually find this kind of information in the “Investor Relations” or “Investor Information” section of the company’s website.  Other good places to look for this kind of information can be found via the resources described in the following link box. 

Yet another thing to look for when evaluating dividend stocks is whether the company has bought back some of its own stock in past years.  What happens is that sometimes companies are sitting on large reserves of cash.  They use this cash to buy back a large portion of its own shares.  The resulting effect is magical for the remaining shareholders.  With fewer shares outstanding (i.e., on the market), subsequent dividend payouts to shareholders actually increase in size.  I will use a simple example to shed light on this point.  Suppose that XYZ Company had ten million shares last year and paid the equivalent of $20 million in dividends, or $2 per share.  Assume that this year it has bought back two million of its own shares and once more decides to pay $20 million in dividends.  Now we simply divide $20,000,000 by 8,000,000 shares giving $2.50 per share.  This represents a twenty-five percent increase in dividend payout for all shareholders.  Do you see the magic?  What’s even more interesting is that these companies will often take advantage of a bear market or even a recession to buy back their own shares, usually at bargain prices.  Therefore, even during harsh economic times it can pay to stick with these companies. 

Believe it or not, there is more good news for the dividend investor.  Investment gains in the form of dividends are taxed at a much lower rate than interest income and at a slightly lower rate than capital gains.  Both Canadian and American tax authorities have recently provided tax incentives to help stimulate investment in their respective economies. 

In conclusion, dividend stocks can represent one of the best and safest ways to invest in the stock market.  Since many dividend-paying companies are large, proven, and stable multinationals, they are less volatile to downturns in the economy.  They are highly resilient during all market cycles, so their stock prices tend to be stable.  In addition, they reward their investors with steady income streams, putting them in a position to take better advantage of the benefits of compounding.  The tax-friendly environment for dividends provides a good means by which investors can better protect their gains.  And finally, some of them surprise investors with high-paying special dividends. 

4. Penny Stocks

Penny stocks represent a more speculative form of investing.  Investing in penny stocks is very risky.  Many consider it a form of gambling.  Penny stocks, sometimes known as micro-cap stocks, are stocks in which both market capitalization and price are low.  Penny stocks are usually priced or valued under a dollar a share although, at times, they can be worth a few dollars.  On occasion they even grow to be worth several dollars a piece.  They are very volatile, meaning that they can both experience sharp gains as well as rapid losses.  In Canada, penny stocks are mostly traded on the TSX Venture Exchange (controlled by the TSX Group) while in the United States they are commonly traded on the OTC Bulletin Board, more commonly referred to as the OTCBB.  In addition, companies that do not qualify for the OTCBB usually trade on what we call the pink sheets.  Although they represent many different industries, penny stocks typically include mining and exploration firms, as well as biotechnology and software companies.  In general, it is advisable to avoid these types of speculative investments since very few of them actually become the goose that lays the golden egg.  But some would argue that it is good to hold a tiny portion (perhaps 1% to 3%) in one’s investment portfolio.  If you do so, then make sure that you take the time to research the company, its products or business ideas, its people, and most importantly, its potential customers and sales.  Ask yourself: “What is so unique about them?”; “Do they own interesting or revolutionary patents?”  Most of all, be sure not to get caught up in all the hype that is generated by both the company itself and other interested parties.  In short, it can be one of the few occasions when you can have some fun.  Just follow Kenny Rogers’ advice – “Know when to hold’em and know when to fold’em!” and you’ll be okay.

Mutual Funds

“The principal role of the mutual fund is to serve its investors.”  – John Bogle, American investor

Mutual Funds are one of the most popular forms of investment among North Americans.  They provide a good means by which you can diversify your investments.  A mutual fund is actually a company that is created in which itself, other firms, and individuals pool their money to purchase various securities such as stocks, bonds, and cash investments.  Investors in a mutual fund are part-owners of its investment portfolio.  Consequently, each investor shares proportionally in the fund’s investment gains (i.e., capital gains, dividends, and/or interest payments) or losses caused by the sale of the securities held in the fund.  Those who wish to invest in a particular mutual fund must buy shares, or units in the fund.  The price for these shares or units, is referred to as the Net Asset Value Per Share (NAVPS), but most people simply call it the NAV (Net Asset Value).  Unlike the price of a stock which changes throughout the trading day, the NAV, or mutual fund share price, is determined only once the stock markets have closed at 4pm EST (Eastern Standard Time).  This makes sense because many mutual funds contain a bundle of stocks and, since stock prices fluctuate throughout the day, it would be nearly impossible to (continuously) figure out the NAV, given all the stocks held in the fund.  There is another fundamental difference in the pricing of a mutual fund as opposed to a stock.  The NAV or price of each mutual fund unit does not go up or down as shares in the fund are bought and sold.  Instead, its price is determined by the market value of the holdings in the fund’s portfolio.  What this means is that mutual fund prices are less volatile than stock prices.  Every mutual fund has a manager, an investment objective, and a reinvestment plan.  A fund’s manager is usually an investment professional who is knowledgeable and experienced in the area of investment for which the fund has been created.  For example, if a certain mutual fund has its holdings concentrated in the energy sector, then the manager will have intimate knowledge of the energy markets and the players found within.  The fund manager is the only one who decides which securities will be held in the fund.  (S)he may decide to sell some securities and buy others at any time to change the composition of the fund.  This is often done to replace poorly performing securities with more promising ones.  The fund’s manager always has the fund’s investment objectives in mind when deciding which securities to buy and sell.  Investment objectives vary from one mutual fund to another.  Some promote growth while others promote steady income or dividend flows.  Others promote stability with safer securities such as bonds and cash investments.  No two funds are alike.  Finally, most mutual funds offer a reinvestment plan in which the mutual fund holders can purchase additional shares, usually commission-free.

Fees and charges

When buying or selling mutual funds, there are generally two types of fees that investors pay: Sales Charges and Management Fees.  There are four types of sales charges: No-Load, Front-end Load, Back-end Load, and Front- and Back-end Load.  Only no-load funds have no sales charges.  You can purchase no-load funds directly from the mutual fund company itself, from big banks, and from some insurance companies, as well as from other financial institutions.  All other mutual funds carry a load.  A load fund entails a sales charge that typically lies between 2% and 5% of the invested amount.  With a front-end load fund, you pay a fixed sales charge at the time of purchase.  Back-end load funds defer sales charges to the time when you sell out.  With some back-end load funds you pay a fixed percentage, while with others the sales charge diminishes in time.  In the latter case you may start with a sales charge of 5% if you get out in the first year, 4% in the second year, 3% in the third year, and so on.  The objective is to keep you invested in the fund for as long as possible.  If you consider buying this type of back-end load fund, make sure that you are in it for the long haul.  Finally, a front- and back-end load fund charges a sales fee both at the time of purchase and sale.

My suggestion is to try to avoid load funds altogether, with the odd exception of purchasing an exceptional or outstanding front-end load fund. 

The second type of fee which will influence your investment decision relates to the management and marketing expenses incurred by the mutual fund company.  Once you have purchased a fund and own it, the most expensive charge you will encounter is the management fee.  In essence, there is money in the fund that will be taken away from the actual investment in order to pay for the salary of the fund’s manager.  A professional manager or investment advisor usually makes a good salary so expect the management fees to be quite high.  What can be even more troubling is the fact that it can be quite difficult for mutual fund investors to determine actually how much is taken out of the fund to pay for the manager’s fee.  This type of information is not readily available to mutual fund unitholders.  In addition, the mutual fund will need money to pay for its sales and marketing efforts.  And in today’s highly competitive investment arena, such marketing fees can really add up.  Added together, the management and marketing fees become known as the Management Expense Ratio (MER).  Precise details about the MER fee structure can usually be found in the mutual fund’s prospectus.  A prospectus is a document that describes the fund’s objectives, characteristics, holdings, manager(s), risks, and fees, all in great detail.  Always be sure to ask the vendor for the fund’s prospectus and read it carefully so that you understand what the fund is all about, its inherent risks, and its associated fees.  Don’t get caught up in any fancy graphics or charts that display past performance of the fund; this should not serve as an indicator for future performance.  As a mutual fund owner, you don’t pay MER fees directly.  Instead, the fees are deducted before the fund’s Net Asset Value (NAV) is calculated.  In other words, each unitholder assumes a proportion of operating costs regardless of whether the fund experiences gains or losses for the year.  It’s kind of like your employer withholding income taxes on your salary before you get your pay check.  This is an important point for you to remember.  Even if the mutual fund loses money, you will still have to pay the fees.  The fund’s manager will still be paid his or her salary despite poor performance of the fund.  Of course, as with any investment, there are no guarantees that the fund will turn a profit.  You and you alone will have to assume the risk and associated costs of holding the fund.  Thus, for an investor, the MER is a key indicator as to how much it costs to hold the fund.  Such costs will also have a significant impact on the investment’s return upon sale of the fund.  This is why there has been a lot of criticism surrounding the mutual fund industry in past years.  There is a broader issue of transparency.  Moreover, it is not always clear or transparent to mutual fund investors what exactly it is they are paying as expenses.  Mutual fund companies have been known to advertise the possibility of good returns often expressed in percentage terms (such as 10% for example), and in charts and graphs.  They are not so quick to emphasize the net returns once the fees have been taken away.  Such fees can easily be as high as 5% or more per year, depending on the fund.  These percentages can really shrink the return on your investment.  So my advice to you is to be very vigilant when shopping around for mutual funds.  Investigate the sales charges and MERs before buying.  And be sure to ask the vendor lots of questions, including what salary is taken to manage the fund.  Finally, don’t assume that past returns will indicate future performance.

Types of Mutual Funds

Mutual funds come in all varieties.  Most firms offer many types of funds and even let you transfer between funds at no extra cost.  This is an interesting benefit because it allows you to re-balance your portfolio at any time.  In other words, you can switch from a fund that is on the decline to one that is on the rise.  And the absence of switching fees makes it really cost effective.  The only catch is that you may only switch to a fund in the same “family”.  So keep this in mind when shopping around for mutual funds.  Since it would be too lengthy for me to describe all existing types of mutual funds I will only focus on the following:

1. Equity Funds
2. Bond Funds
3. Money Market Funds
4. Balanced Funds
5. Growth Funds
6. Value Funds
7. Dividend Funds
8. Large, Mid, and Small-cap Funds
9. Specialty funds
10. Global Funds
11. Index Funds

1. Equity Funds

Equity funds invest in company stocks.  Their main objective is to realize capital gains.  Some choose funds with well established companies, also known as blue-chip companies, that are generally safer and of good quality.  While others will choose funds with less established companies that can provide higher gains but are riskier at the same time.  No two equity funds are alike, so be sure to examine the individual holdings mixed in the fund.

2. Bond Funds

Bond funds, sometimes called Income funds, invest primarily in safe, high-yielding government and corporate bonds.  They are seen as very safe investments.  Fees for these types of funds are generally lower than other types of mutual funds because the fund manager does not need to change the composition of the fund as would be the case with those that hold stock.

3. Money Market Funds

Similar in terms of risk and fees to bond funds are Money Market funds.  They are seen as the safest type of mutual fund.  These funds have holdings in short-term money market instruments such as treasury bills, notes, and short-term bonds with good credit ratings.  Their share price is usually fixed at around $1.

4. Balanced Funds

Balanced funds invest proportionally in both stocks and bonds.  The idea is to minimize risk without compromising the possible long-term appreciation usually associated with stocks.

5. Growth Funds

Growth funds are riskier since they invest in growth stocks.  Such funds perform well in periods of economic growth and expansion but usually do poorly in other economic cycles.

6. Value Funds

These mutual funds invest primarily in value stocks.  They seek to choose companies that are currently undervalued or under-priced in the market, in the hope that they will bounce back.  Therefore, some level of risk is usually apparent.  These funds tend to do better in periods of economic prosperity but, depending on the holdings, they can also perform well at other times.

7. Dividend Funds

These funds invest in the stock of large corporations that consistently issue dividends.  The idea is to make additional revenue other than capital gains.  Dividend fund unitholders may choose to have dividends reinvested in the fund as additional units or to receive cash in the account instead.  In some cases, you may be obligated to reinvest the dividends as additional units; be sure to carefully consult the fund’s prospectus on this issue.  Just as for dividend stocks, I recommend that you take the dividends as cash and use it to diversify into something else.

8. Large, Mid, and Small-cap Funds

These funds specialize in stocks that lie within a certain range of market capitalization.  Small and mid-cap funds are riskier but can be more profitable, especially when the economy is on the rise.  Large-cap funds are less volatile during different economic cycles as they often hold stocks of big, high-quality corporations that are market leaders in their respective industries.

9. Specialty Funds

Specialty or Sector funds tend to concentrate their holdings in a group of companies from a particular industry or sector such as biotechnology or telecommunications.  Other specialty funds specialize in the securities of particular countries such as China or Brazil.  Specialty funds that hold securities from other countries are subject to additional risks due to currency fluctuations and exchange rates.  Foreign securities are paid for in currencies other than the dollar.  And if the foreign currency loses in value over the dollar during the investment period, then any capital gains on the sale of the stocks will be reduced once proceeds are converted back to dollars.  On the flip side, if the foreign currency gains in value over the dollar, then additional gains will be made on top of the capital gain since the currency now buys more dollars.  Sector or industry-specific funds are subject to a different kind of risk.  Many industries or sectors, or even countries for that matter, are sensitive to specific economic factors.  For additional insight on the subject, consult the Economic Indicators and Sectors & Industries sections in the previous chapter.

In sum, specialty funds are generally more speculative and volatile than other types of mutual funds.  They can be some of the most profitable types of funds but are also vulnerable to swings in the industry or the economy.  Finally, MERs for specialty funds tend to be higher than other fund types.

10. Global Funds

Global funds can be a mixture of Equity, Bond, and Money Market funds.  They offer diversification into foreign markets by selecting the best prospects from various locations around the world.

11. Index Funds

Index funds are arguably the best type of mutual fund you can buy.  In my opinion, index funds are, with a few possible exceptions, the only kind of mutual fund one should buy.  I say this because index funds, sometimes referred to as passively-managed funds, outperform the majority of actively-managed funds time and time again.  A fund that is actively managed means that its manager changes the holdings or composition of the fund while a passively managed fund means that the holdings are never changed by the manager.  That is why passively- managed funds, such as index funds, carry lower management fees.  Feel free to consult Chapter 5 – Avoid Mutual Funds...Embrace Exchange-Traded Funds for a more extensive debate on the issue.  But just what is an index fund?  An index fund attempts to match the performance of a particular market index by buying the exact same stocks found in that index.  For example, there are several index funds available that are composed of the five hundred stocks found in the S&P 500 index.  Investing in index funds is known as passive investing.  Once more, passive means that the fund manager is passive or does not have to actively change the composition of the fund’s holdings by buying and selling a whole bunch of different stocks.  Two significant benefits derive from passive investing.  The first is that since the manager does not need to change stocks in the fund, (s)he will require a much smaller salary.  In addition, since stocks are not replaced by others, there will be no additional trading or commission fees.  These cost savings will benefit you the investor.  Due to all these cost savings index funds usually have low Management Expense Ratios (MERs).  MERs for index funds generally lie in the 0.1% to 1% range.  This can make a huge difference in the profitability of your investment, as most actively-managed funds carry MERs of 1.5% to 5%.  If an index fund makes an annual return of 10% and the MER fees are 1%, you still get a 9% return on your investment.  The same cannot be said about other actively-managed funds.  Index funds are also available for bond lovers.  There are several index bond funds available and they work in a similar way by tracking a particular bond index. 

For the most part, index funds have traditionally outperformed other types of mutual funds. The only apparent disadvantage of owning an index fund is that it will barely ever outperform the index or market that it tracks.  In summary, index funds carry significant advantages and should be worthy of consideration for inclusion in any investment portfolio.

Exchange-Traded Funds (ETFs)

Exchange-Traded Funds represent one of the most exciting investment vehicles available to investors.  Extremely similar to index funds, ETFs offer a similar means of passive investing.  ETFs are similar in nature to mutual funds as they carry an assortment of different securities in the fund.  However, ETFs are traded as shares on stock exchanges.  They can be bought and sold at any time during the trading day.  Unlike mutual funds, there is no minimum number of shares (or dollar amount) you have to buy; you can even buy a single share of an ETF if you want to.  ETFs attempt to replicate the performance of a particular stock market index, bond index, a specific market sector or industry, or a certain geographic region.  Many investors choose ETFs because they offer instant diversification.  Because a single ETF will have many different holdings, they are less risky than owning individual stocks.  Even though certain holdings in an ETF may perform poorly others may do better bringing up the overall value of the entire fund.  Don’t put all your eggs in one basket, they say.  ETFs provide an excellent means by which you can follow this sound investment advice. 

The other main advantage of holding ETFs in one’s investment portfolio is that annual expenses and management fees are significantly lower than those of mutual funds.  Management Expense Ratios (MERs) typically range between 0.1 and 0.65%.  The fees are very low because very little active management is required by the fund’s sponsor.  In addition, ETF holders are subject to less exposure to capital gains taxes than are mutual fund holders.  In Chapter 5 – Avoid Mutual Funds...Embrace Exchange-Traded Funds I will make many other detailed comparisons between mutual funds and exchange-traded funds.

What is really appealing about ETFs is the variety of choices available to investors.  There are literally hundreds of ETFs to choose from.  And it seems that a new one is popping up every other week.  Because there are so many ETFs available, it is difficult to categorize them.  Nonetheless, most of them fall under one of the following categories:

• Broad Market Index (e.g., Dow, S&P 500, S&P TSX 60)
• Market Capitalization (e.g., Small, Mid, or Large-cap)
• Industry or Sector (e.g., Healthcare, Energy, Biotechnology)
• Geographic Location (e.g., China, India, Mexico)
• Fixed-Income (e.g., bonds and cash investments)
• Commodities (e.g., gold, silver, oil)
  
  

Top ETF providers: - iShares http://www.ishares.com - iShares Canada http://www.ishares.ca - State Street Global Advisors http://www.ssgafunds.com/etf/index.jsp - Vanguard ETFs https://flagship.vanguard.com/VGApp/hnw/FundsVIPER?gh_sec=n - Select Sector SPDRs http://www.sectorspdr.com/ - PowerShares http://www.invescopowershares.com

With such a wide array of ETFs to choose from, you can decide to invest in a very specific area in which you believe the market will progress.  With all the tools and market information freely available on the Internet, even the average investor can generate solid returns by selecting the right ETFs.  In the previous chapter I covered Economic Indicators, Sectors and Industries, Market Indices, and Market Cycles.  I felt that it was important for me to cover these topics because it will provide you will a solid foundation on which you can base your investment decisions.  Knowing how the markets work, which trends are on the rise, which sector or industries are affected by which factors, and how economic variables direct market cycles will help you make more enlightened investment decisions.  More specifically, they will help you choose the most promising ETFs.  In Chapter 7 – Do it Yourself! Online Investing I will provide you with access to useful online tools that will complement your investment knowledge.  You will be acting like an investment pro in no time.

ETFs carry few disadvantages.  Since ETFs are traded like stocks, trading fees are inevitable.  You will have to pay a commission or brokerage fee each time you buy or sell an ETF.  Such commission fees can really add up if you trade frequently.  Another disadvantage is that ETFs are not always eligible investments for IRAs and 401(k)’s (but they are for RRSPs).  Be sure to ask your employer or plan’s sponsor if ETFs are eligible.  The only other thing that you have to be careful of when buying ETFs relates to currency exchange.  If you buy an ETF on a foreign market using a foreign currency, you should keep track of the exchange rate.  Because, once you sell the ETF, proceeds in the foreign currency will need to be converted back to your own currency.  Depending on whether your own currency has appreciated or depreciated in value, you can either lose or make additional returns on your investment. 

All in all, though, ETFs represent an excellent investment vehicle, not only for the novice investor but also for the seasoned pro.

To find out more about ETFs be sure to check out: - Yahoo! Finance – ETFs http://finance.yahoo.com/etf - ETF Guide http://etfguide.com - MorningStar.com – ETFs http://www.morningstar.com/Cover/ETF.html - ETF Investor http://etf.seekingalpha.com/ - ETF Zone http://www.etfzone.com - SmartMoney.com - ETFs at a Glance http://www.smartmoney.com/siebert/ETF/etfTracker/index.cfm?story=intro - ETF Database http://www.etfdb.com/

American Depositary Receipts (ADRs)

Stocks of some foreign companies are traded as American Depositary Receipts (ADRs) on U.S. stock exchanges such as the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the NASDAQ.  ADRs do not represent the actual shares of the foreign company; rather, they are certificates which represent its stock.  When you own an ADR you have the right to obtain the foreign stock it represents.  Investors find it convenient to own ADRs since they are traded on U.S. exchanges and in U.S. dollars.  The price of an ADR is usually close to the price of the foreign stock in the home market.  ADRs are issued by U.S. depositary banks such as The Bank of New York.  Depositary banks list company information (in English) to investors and perform the necessary currency conversion to U.S. dollars when dividends are paid to investors.  Of course, the bank will charge fees for these services and will deduct them from the dividends or other distributions on the shares.

ADRs represent an easy and cost-efficient way in which you can diversify your investment portfolio by tapping into some of the alluring growth opportunities that lie in foreign countries, especially in emerging economies such as China and India.  Without ADRs, you would need to find a broker who has a seat on a foreign exchange in order to trade the stock, obtain the foreign currency to buy the stock, and perhaps even the services of a foreign language translator to help you understand the company reports and financial statements of the foreign firm.  ADRs simplify the process a great deal.  Another critical issue about investing in foreign stocks lies in the regulatory and reporting requirements companies must follow when disclosing company information and financial statements to its investors.  ADRs that are traded on a U.S. stock exchange must adhere to standards that are set by the U.S. Securities and Exchange Commission (SEC).  In addition, financial and accounting statements reported by foreign companies must follow U.S. Generally Accepted Accounting Principles (GAAP).  SECand GAAP rules are among the strictest in the world, meaning that they are in place to protect investors.  Therefore, for the most part, investing in ADRs becomes a much less risky way to invest in companies of foreign nations.  Nonetheless, as with any type of investment, there are risks.  Investing in ADRs entails the exact same risks associated with investing in any other company stock.  And even though most of the currency risk is alleviated when buying ADRs in U.S. dollars, some risk remains.  For example, if the U.S. dollar falls against the currency of the foreign country, dividend payments will shrink.  Conversely, if the dollar strengthens, it may decrease the underlying value of the shares.  One must also consider geopolitical risks.  Foreign companies, especially those in emerging markets, can be subject to unfavorable changes in the political, legal, and regulatory environments.  Finally, it may take longer to receive company information or financial statements in English and this can provide further risk.

By and large, though, ADRs provide an excellent means by which you can look outside of the traditional investment box and broaden your investment holdings.

To further explore foreign investment opportunities by means of ADRs, I recommend the following websites: - BNY Mellon Depositary Receipts http://www.adrbny.com - ADR.com http://www.adr.com

Commodities

Until recently, investing in commodities was only open to speculators, large businesses, and other wealthy organizations.  These parties buy and sell large quantities of commodities in the form of Futures Contracts and Options in the hope of making a profit, or simply out of business necessity.  Engaging in such transactions is very costly, as there are usually minimum quantities to purchase.  Standardized contracts for certain commodities are upwards of $50,000.  But nowadays, there are other ways in which even the average investor can participate in the trading of popular commodities without having to disburse large sums of cash.  I will describe the means or methods by which one can invest in popular commodities, namely precious metals and stones such as gold, silver, and diamonds, as well as one commodity that seems to be the most precious of all these days – black gold (oil).  In addition, you can now bet on currency commodities by means of ETFs.  Feel free to apply the methods of investing to other commodities not listed here that may interest you or that you know a lot about.  Let’s begin with the one commodity that has been valued by investors and traders for thousands of years – gold.

Gold

“Gold still represents the ultimate form of payment in the world.”  – Alan Greenspan in 1999, then chairman of the Fed.

Gold is seen as a dual commodity because it is both a precious metal and a form of currency.  For thousands of years, gold has been regarded as both a store of wealth and a global currency.  Besides being a thing of beauty, gold serves many different purposes.  Throughout time the precious metal has served many different industrial uses, has been regarded as an essential component of jewelry, and has been used as a valuable exchange medium.  People invest in gold for many different reasons.  Some want to have a different type of asset class in their investment portfolios.  Others like it because it is a tangible asset, unlike a stock, bond, or currency (excluding coins), which is simply a piece of paper.  Whereas a currency can lose its value, a bond can default, and a stock may sink, gold is gold and it cannot erode or disappear.  Some like the shiny metal because it does not take up much physical space and can be easily hidden from a spouse, creditors, lawyers, the government, and other parties.  A metric ton of gold only requires the space equivalent to just over a cubic foot.  Some investors are attracted to gold in order to protect themselves against a rise in inflation.  According to the World Gold Council, for at least the last two hundred years the price of gold has kept pace with inflation.  Finally, others use gold as a means of currency speculation.  Gold is priced in U.S. dollars, British pounds, the euro, and Japanese yen.  As an example, a speculator who believes the U.S. dollar will decline in value may buy gold.  If the dollar does decline, the price of gold itself is likely to remain constant against other currencies.  So when the speculator later sells the gold, (s)he can realize a profit.  This is why gold has a negative correlation with the U.S. dollar.  In the past thirty years, gold and the U.S. dollar have consistently moved in opposite directions.  Whenever the U.S. dollar declines in value, many investors seek a safe haven in gold.  That is why many investors choose to hold gold as an asset in their portfolios.  It serves as a means of preserving value.  Furthermore, in times of war, political instability, and economic crises, gold tends to gain in value.  That is why holding gold in one’s portfolio can help offset market surprises, thus improving overall performance. 

1. Some Facts about Gold

• The purity of gold is measured in carats
• Pure gold has 24 carats
• The purity of gold is also measured in fineness (i.e., parts per thousand); so 18 carats is 18/24th of 1000 parts, or 750 fineness
As mentioned previously, gold is priced in U.S. dollars, British pounds, Euros, and Yen.  The most common unit for measuring gold is an ounce.



Gold Unit Conversion Table
1 ounce	=	28.34952 grams
1 troy ounce	=	31.10348 grams
1 pound	=	14.58333 troy ounces
1 kilogram	=	32.15072 troy ounces
1 metric ton	=	32,150.75 troy ounces

Table 13 – Gold Unit Conversion Table

At the end of 2001, world gold reserves were estimated at approximately 145,000 tons, according to the World Gold Council.  About one fifth of the reserves are held by various countries’ central banks; the United States, Germany, and France have the largest gold reserves as seen in the table below.  These countries like to keep large reserves of gold in the event of a national crisis. 

Largest Gold Reserves (in tons)
Country	Reserves
United States	8,135.1
Germany	3,427.8
France	2,825.8
Italy	2,451.8
Switzerland	1,290.1
Japan	765.2
Netherlands	694.9
China	600.0
Source: The World Gold Council

Table 14 – Largest Gold Reserves (in tons)

2. Ways to invest in Gold

There are numerous ways in which one can invest in gold.  But for the average investor, the most common ways include:

• Gold Bars and Coins
• Gold Certificates
• Gold-Denominated Currency Accounts
• Gold Stocks and Mutual Funds
• Gold Exchange-Traded Funds (ETFs)

3. Gold Bars and Coins

Buying gold bars (bullion) and coins provide a simple means by which one can enjoy the beauty of the glittering asset.  Bars and coins vary in terms of their weights and sizes.  Gold coins are very popular as with time they become rarer and their value can easily surpass their measured weight value.  Many countries’ national mints will issue gold coins as legal-tender currency and sell them to the public.  Popular national gold coins include the Canadian Gold Maple Leaf, the American Gold Eagle, the Chinese Gold Panda, and the South African Krugerand.  Some investors and hobbyists choose to collect coins as an alternative form of investment (see Chapter 8 – Alternative Investment Strategies for more information on the subject). 

Gold Bars and Coins links: - Royal Canadian Mint http://www.mint.ca - The United States Mint http://www.usmint.gov - Grendon International Research – The Industry Catalogue of Gold Bars Worldwide http://www.grendon.com.au/goldbarscat.htm

4. Gold Certificates

Gold certificates are convenient for the investor who wants to invest in gold without the hassle of acquiring, storing, and insuring the gold itself.  The financial institution, such as a bank for instance, that issues gold certificates will take care of storing and protecting the gold for the owner.  Some would argue that owning gold certificates is not the same as holding the real thing.  They are just pieces of paper.  And should something bad happen to the bank, it is not guaranteed that you can claim the actual asset.  For the most part, though, it is quite safe to hold gold certificates, as most banks that issue them are quite reliable.  If you seek extra insurance you can always purchase gold certificates from the Perth Mint Certificate Program (PMCP).  It is the only government-guaranteed gold certificate program in the world.

- Perth Mint Certificate Program (PMCP) http://www.perthmint.com.au/certificateprograms.aspx

5. Gold-Denominated Currency Accounts

Gold currency accounts are similar to electronic currency accounts such as PayPal (owned by eBay).  With PayPal or other e-money accounts, people can purchase goods or services using electronic currency.  Canadians open PayPal accounts in Canadian dollars and Americans open them in U.S. dollars.  Sometimes, though, the problem is that not all online merchants will accept your currency.  With a gold currency account, however, the gold itself becomes the currency.  People fund their accounts by buying units of the metal using their own currency.  Units are typically sold in grams of gold.  Most account providers actually hold the equivalent in gold in stock as collateral.  Account holdings can be used to purchase goods and services in equivalent grams of gold.  Some online businesses accept such payments.  The value of the account holdings is contingent on the price of gold relative to the currency with which it was bought.  As the price of gold rises, so does the value of the account holdings.  But should the price of gold decline, the value of the holdings will follow.  Smaller investors actually see this as a way to speculate and make profits on the price of gold.  They simply fund the account when the price of gold is low and sell when the price rises to a target level.  There is no need to spend $50,000 on gold futures to reap the same benefits.  But there are risks for both speculators and non-speculating account holders.  The risk is that the price of gold can drop significantly.  Although gold is a fairly stable currency, it can easily fluctuate downward.  Therefore, one must be careful when deciding how much to invest in a gold currency account.

Selected Gold Currency Account Providers: - e-Gold.com http://www.e-gold.com - GoldMoney http://goldmoney.com

6. Gold Stocks and Mutual Funds

An indirect way in which one can invest in gold is by purchasing shares in companies that are active in the gold industry.  For example, gold-mining companies are involved in the production of gold itself; they mine tons of ore from the earth from which they extract gold nuggets.  Other companies are solely involved in searching for gold.  Investing in gold exploration companies is extremely speculative and risky, as very few of them actually find reserves that are large enough to justify building a mine for production.  The share price of gold-related companies tends to parallel the price of gold.  As the value of gold rises, so do gold stocks, as the payout for the mined mineral will increase.  It is quite risky to invest in single companies.  Therefore, some investors choose to spread the risk by investing in mutual funds that contain several gold-producing and gold-exploration companies in order to balance risk and return.  In addition, the mutual fund often includes a hedging strategy to safeguard against the movement of gold prices.  In other words, they buy gold futures at various prices to “even out” variations in the price of gold.  Before investing in gold stocks or mutual funds, be sure to do your homework.  The first thing you should do to is not get caught up in all the hype and excitement that is often generated by the company itself as well as by other interested parties or vendors.  Be very vigilant and skeptical when reading company news or information on these companies’ websites.  Ask yourself a few questions about the company, namely:

• Are they producing the gold or exploring for it?
• How many reserves are left in their mines?
• Are they profitable?
• Do they pay good dividends?
• Do they operate in a country that has political risks?
• Does the company use a hedging strategy?

You really need to exercise more caution when considering investing in gold companies, as they are much riskier and volatile.  If you are simply betting on a rise in the price of gold itself, then use one of the other methods described in this section instead. 

The Bre-X Gold Scandal Do you want to hear the story about one of the biggest stock scandals in Canadian history? Fraud exists everywhere, and the stock market is no exception. Investors, big and small, were taken on a wild ride in the mid-1990s. Bre-X Minerals Ltd, a Canadian junior mining company, was founded in 1989 by a promoter named David Walsh. With the advice of a prospector named John Felderholf, Walsh bought a property in the middle of a jungle near the Busang river in Borneo (Indonesia) that was said to be built on large deposits of gold. The pair hired a Filipino geologist named Michael de Guzman, who evaluated the site and estimated that there were approximately seventeen million ounces of gold worth around $25 million at the time. In the next few years, both the estimated size of the deposit as well as the price of Bre-X’s stock grew significantly. What originally started as a $21,000 investment had suddenly grown, at least on paper, into a $6 billion golden egg as Walsh was able to attract key players from the industry in order to lure big investors. Bre-X grew from a penny stock on the Alberta Stock Exchange to sprout into a $286 stock on the Toronto Stock Exchange by 1997 as estimated gold reserves had reached 200 million ounces, or 8% of the entire world’s gold supply. Things were all going well until it was discovered that original samples from the site had been salted with gold dust shaved-off gold jewelry. A couple of independent companies, Strathcona Minerals and Freeport-McMoRan, were brought in to take their own samplings and make their own analyses. They discovered that there were insignificant amounts of gold and that, essentially, the deposits were worthless. A frenzied sell-off of shares followed, and Bre-X lost 86% of its value in just two days. The stock was delisted, as angry investors were hung out to dry. Even large investors such as pension funds lost millions. The Ontario Municipal Employees Retirement Board, the Quebec Public Pension Fund, and the Ontario Teacher Pension Plan, respectively, lost forty-five, seventy, and one hundred million dollars. As with any major fraud, even the best of them were fooled.

7. Gold Exchange-Traded Funds (ETFs)

Like clockwork, gold ETFs follow the day-to-day movement of the price of gold.  Some gold-related ETFs have holdings in gold mining and/or exploration companies.  In other gold ETFs, the assets are comprised of actual gold bars that are held in a custodial bank.  Therefore, they are extremely safe.  Here, you simply need to buy shares in the ETF without having to worry about storing and insuring the asset.  They are very similar to gold certificates.  A single share usually represents a tenth of an ounce of gold.  Using this unit of measurement is convenient, as it places the price per share at a reasonable amount and it makes it easy to calculate or compare a share with the price of gold.  For example, if the price of gold is $750 an ounce, a share of the gold ETF will be approximately one tenth of that, or $75.  In other words, ten shares of the gold ETF are equivalent to about an ounce of gold.  Shares can be bought or sold on the stock market at any time during the day.  Therefore, it provides a quick and easy means by which one can buy into or out of gold.



Gold ETFs: - iShares COMEX Gold Trust http://us.ishares.com/product_info/fund/overview/IAU.htm (trades under the symbol IAU on the AMEX and IGT on the TSX) - SPDR Gold Shares https://www.spdrs.com/product/fund.seam?ticker=GLD (trades under the symbol GLD on the NYSE) - iShares Canada Gold ETF http://www.ishares.ca/product_info/fund_overview.do?ticker=XGD

Be sure to consult with your relevant tax authorities about the level of taxation derived from any gold investment.  There will be different tax implications, depending on which investment strategy you choose; so be sure to use the one that is the most tax-efficient.  In Canada, investors are even allowed to hold gold bullion in their RRSPs.  So, more than ever, it is easier to hold gold as an asset class in one’s investment portfolio.

8. Factors affecting the price of Gold

As it is for most commodities, the price of gold is driven by the forces of supply and demand.  Most gold that has ever been mined throughout history still exists.  Thus, it is not really the supply side of the equation that will drive prices.  For the most part, it is the demand for gold that will influence prices, even though other factors such as consumer sentiment may also come into play.

To learn more about gold I recommend the following site: - The World Gold Council http://www.gold.org

Silver

Similar to gold, silver has been regarded as a form of currency and a store of value.  Like gold, silver is priced in ounces.  And even though silver is worth much less per ounce than gold, its price does tend to follow that of gold.  Of course other factors, such as industrial demand for the metal, will influence its price.  Ways of investing in silver are the same as those described above with gold.

More on silver: - The Silver Institute http://www.silverinstitute.org - Current London Silver Fixing http://www.lbma.org.uk/pages/index.cfm?page_id=54&title=silver_fixings - The iShares Silver Trust http://us.ishares.com/product_info/fund/overview/SLV.htm (Trades under the symbol SLV on the NYSE)

Diamonds

Unlike gold or silver, diamonds are not really seen as a store of value or a medium of exchange.  Their value may be more sentimental in nature.  About 20% of the diamonds produced goes into the making of jewelry.  The rest is reserved for industrial uses such as creating drill bits and surgical instruments.  Natural diamonds vary tremendously in terms of quality and value.  With jewelry, a diamond’s quality and value are determined by the four C’s: Carat, Color, Clarity, and Cut (or shape).  So there is no set price per unit of weight.  Other factors can influence the price of diamonds.  Increased demand can move the price upwards.  Supply is actually controlled by an elite few.  The DeBeers Group and BHP Billiton control a big chunk of the global market.  Therefore, they alone have the ability to set prices.

Big diamond players: - The DeBeers Group http://www.debeersgroup.com - BHP Billiton http://www.bhpbilliton.com/bb/ourBusinesses/diamondsSpecialtyProducts.jsp

The biggest diamond producing countries are, respectively, Botswana, Russia, South Africa, Angola, and Canada.  Canada is becoming a major participant on the world diamond stage.  And there are certainly opportunities that lie ahead.  The best way to invest in diamonds is to buy shares in diamond mining companies.  But I say this with caution as they are very risky investments.  As with gold mining companies, be sure to research the company.  Investing in these companies is not something you do overnight.  You have to be patient enough sometimes waiting several years before seeing a return on investment.  Only about one or two percent of diamond exploration or prospecting companies ever justify the creation of a mine.  Nonetheless, it can prove to be a profitable, albeit speculative, investment should you choose the right company. 

Information on the diamond industry: - The World Diamond Council http://www.worlddiamondcouncil.com - DiamondFacts.org http://diamondfacts.org - Natural Resource Canada – Canada: A Diamond-Producing Nation http://www.nrcan.gc.ca/smm-mms/busi-indu/dpn-npd-eng.htm - ExhibitorResearch.com - Diamond Plays Search http://www.exhibitorresearch.com/s/Diamond/iSearch.asp - The Diamond Hunter http://www.thediamondhunter.com

Oil

Oil, sometimes referred to as black gold, is undoubtedly the world’s most popular commodity.  Think about it for a minute.  Nearly everyone, especially in industrialized nations, is dependent, either directly or indirectly, on oil.  Individuals need oil (which is refined into gasoline) to drive their cars and heat their homes.  Businesses use oil to feed their energy needs and ship their products to their customers.  Here are some quick facts about oil:

• One barrel (of oil) = 159 Liters or 42 U.S. Gallons
• Thousands of products are derived from crude oil.  Such products include: gasoline, jet fuel, lubricants such as petroleum jelly, synthetic fibers, synthetic rubbers, plastics, and even perfumes.
• Estimated world crude oil reserves were estimated to be about 1.2 trillion barrels at the end of 2005 according to BP (formerly British Petroleum).
• OPEC (The Organization of Petroleum Exporting Countries) is said to hold about 75% of world reserves.  OPEC member countries include Algeria, Angola, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela (see http://www.opec.org).
• The United States, Europe, and Japan alone consume about half of the world’s annual oil supply.
• The price of crude oil is determined by traders on three major international petroleum exchanges – The New York Mercantile Exchange (see http://www.nymex.com), The International Petroleum Exchange in London(see http://www.ipe.uk.com), and The Singapore Exchange (see http://www.sgx.com).

As North Americans, we are highly addicted to and dependent on this commodity.  There have been efforts made in the last few decades to use alternative and renewable sources of energy.  But the fact of the matter is that we just can’t get enough of the commodity to feed our needs.  Americans are especially addicted to oil as they alone consume about 25% of annual world production.  World demand for oil has been rising at a relentless pace in recent years, thanks in large part to the energy-hungry economies of China and India.  But the bad news is that supply is not keeping up with demand.  According to the CIA’s World Factbook, estimated world oil production in 2003 was 79,650,000 barrels per day while demand was 80,100,000 barrels per day.  As you can see, statistical evidence illustrates the imbalance between supply and demand.  Many experts estimate that we are currently reaching (or are close to reaching) the peak of crude oil production and that we are now starting to deplete remaining reserves.  In fact, there has been no major oil discovery in the past fifty years.  According to the Energy Watch Group (see http://www.energywatchgroup.org) production has begun to decline in 2006 to 81 million barrels per day (Mb/d) and they estimate production to lower to 58 Mb/d in 2020 and down to a measly 39 Mb/d in 2030.  And just think of what demand for oil may amount to by then, especially with emerging, energy-hungry, China and India.  The big oil companies and national oil companies are struggling to find new reserves that are large enough to create wells to extract the oil.  What’s worse is that it is extremely expensive to find bountiful new reserves. 

Aside from the problems of supply and demand, geopolitical concerns have also disrupted the flow of oil on world markets and have added a premium to its price.  The situation never seems to improve as there is constant instability in the Middle East (which contains the majority of oil reserves).  These combined factors (as well as others not mentioned) are enough to suggest that we will very unlikely ever see the price of oil drop below $60 per barrel.  Many industry experts believe that in the very near future we will hit the $100 per barrel mark, and $200 within the next decade.  Just a few years ago (in 2003) the price of crude oil was around $30 per barrel.  It has more than doubled since.  What price do you think it will be in ten years?  My advice is to make the best of a bad situation.  Although there is not much you can do about gas prices at the pump (perhaps with the exception of buying and driving a hybrid car), you can invest in oil.

Ways to invest in Oil

1. Oil Stocks

Buying shares of big oil companies can represent an excellent means by which you can invest in the commodity.  The big oil companies (see link box below) are extremely profitable because of current high oil prices.  With record profits in recent years, many of them provide nice dividends for their investors.  In addition, many of them are using their very large cash reserves to buy back their own shares; this has the effect of increasing the dividend yield for current investors.  And think about it: there will be no new major competitors that will enter the industry, as it is much too costly.  So these companies are in a very good position to remain profitable for a very long time.



Big oil companies: - Exxon-Mobil http://www.exxonmobil.com - Chevron http://www.chevron.com - Conoco-Phillips http://www.conocophillips.com - BP http://www.bp.com - Royal Dutch Shell http://www.shell.com - Petro-Canada http://www.petro-canada.ca - Imperial Oil http://www.imperialoil.ca

2. Oil-related ETFs and Mutual Funds

Oil funds represent an effective means by which one can invest in oil.  Just like with oil stocks, oil funds tend to move in harmony with the price of crude oil.  And the main advantage of investing in an oil fund is that you are actually purchasing the stocks of many oil-producing companies and perhaps some exploration and oil-services companies.  In addition, you may receive dividends from several companies.  Therefore, oil funds are a good bet.

3. Oil Sands to the Rescue!

Oil sands, sometimes called tar sands or bitumen sands, are essentially a combination of sand, clay, water, and bitumen.  Bitumen is a degraded form of oil which, when chemically processed, becomes oil.  The process of converting bitumen into oil is quite complex and expensive.  The upside is that there is no need to drill for it.  Rather, it can simply be mined from an open sand pit.  Ever since the price of crude oil has exceeded the $60 per barrel mark, producing oil from tar sands has become more economically feasible.  This is good news for oil-hungry nations such as the United States, China, and India because, as mentioned previously, conventional oil reserves are starting to decline while demand is not.  According to the Alberta Department of Energy, Canada ranks second in proven oil reserves (15% of world reserves) after Saudi Arabia.  And most of these reserves, over one hundred and seventy-four billion barrels, lie in Alberta’s three major oil sand deposits in northern Alberta, an area larger than the state of Florida.  It is estimated that there are reserves of roughly the same size located in the Orinoco tar sands in Venezuela.  In Alberta, only 2% of the resources have been extracted to date.  Therefore, there is an enormous reserve left to exploit.  This is good news for North American individuals, businesses, and governments.  For Canada, it means an increase in economic wealth.  For the United States, the world’s largest consumer of oil, it means that it can obtain the precious commodity from its closest trading partner while reducing its dependency on Middle-Eastern countries.  Some of the biggest players on the Alberta oil sands scene include, but are not restricted to, Suncor, Shell Canada, Chevron, the Syncrude Consortium, and the Canadian Oil Sands Trust.  Together, these companies (as well as others) have made capital investments of over $100 billion.  Returns on these significant capital investments are already starting to pay off, as these players are recording mammoth profits.  If you are considering investing in oil, be sure not to overlook opportunities found in oil sands.



Site covering hundreds of oil and natural gas companies: - OilPatchUpdates.com http://oilpatchupdates.com - Oil and Gas Investor http://oilandgasinvestor.com

 

Mining newspaper with information on diamond, gold, and oil exploration and mining companies (as well as other resources): - The Northern Miner http://www.northernminer.com

Currencies

Until recently, the average investor could not easily invest in currencies as “commodities” in and of themselves (other than buying futures contracts).  But thanks to new currency-related ETFs called CurrencyShares by Rydex Investments, investors can bet on a particular currency or even against the U.S. dollar vis-à-vis another currency such as the Euro.  The ETFs hold the actual currencies rather than futures contracts.  The foreign currencies are held in depositary banks; so they are very safe.  For the moment CurrencyShares are available for the following currencies: the euro, the British pound, the Japanese yen, the Canadian dollar, the Australian dollar, the Swiss franc, the Swedish krona, and the Mexican peso.  But don’t be surprised to see new currencies added in the future.  The ETFs are traded on the New York Stock Exchange (NYSE) and are bought and sold in U.S. dollars.  Although there is no portfolio manager handling the currency trust, there are expenses that shareholders incur.  Such expenses are called Sponsor Fees.  Make sure to examine how they are calculated and how they will affect the return on your investment.  Some American investors will view this type of cash investment as a hedge against the devaluation of the U.S. dollar.  In other words, it can be a means by which you can protect the “purchasing power” of your holdings.  Investing in currencies is a complicated and speculative proposition, at the very least.  Many different factors affect the valuation of a given currency.  Nonetheless, holding a small portion of this type of cash investment in one’s portfolio can be a good strategy.

- Rydex Investments - CurrencyShares http://www.currencyshares.com

 

Continue with Chapter 4 - General Investing Guidelines & Tips...




 


© Dan Fournier, 2007-2011