How will your investment make money?

After two years of savings and sacrifices—sweat and overtime—you finally accumulated enough money to start investing outside of your retirement account. You just spent an afternoon with your new agent, and they discussed countless investment options with you, explained each one in detail, and made you dizzy.

Your broker shows you several hypothetical scenarios, outlining the overall rate of return you might get in each situation, until you finally decide to buy some stocks in local companies that you are familiar with.

But when you drive away from their office, you think, “What am I going to get from it, and how will I get it?”

Key points

  • When considering the performance of an investment, it is sometimes easy to be distracted by simple price changes that it has returned (or is expected to return).
  • However, in addition to capital gains, investments can also generate other forms of value, including interest, dividends, and possible certain tax deductions.
  • You should not simply consider changes in prices, but should take all these value streams into account, the so-called “total return” of investment.

4 investment ratios that can help you make money

interest

Interest income is paid on any type of debt instrument as compensation for loaning the investor’s principal to the borrower or issuer. This type of income is paid for by several different types of investments, as follows:

  • Fixed income securities, such as CDs and bonds. The interest rate is usually preset and lasts until the security matures, or is redeemed or put down.
  • Current deposit accounts, such as checking, savings, and money market accounts. Depositors receive interest from depository institutions as compensation for depositing cash in their accounts.
  • Fixed annuity pays a fixed interest rate on the basis of deferred tax payment until maturity.
  • For mortgage loans financed by the seller, the seller charges an agreed interest rate on the principal loaned to the buyer.
  • Mutual funds that invest in the aforementioned instruments.

No equity of any kind pays any kind of interest. Each of these debt instruments pays a prescribed interest rate. The interest rate is usually fixed, but it can vary according to the terms of the investment.

The interest rate of a demand deposit account usually fluctuates based on changes in interest rates, while the interest rates of bonds, CDs, and fixed annuity contracts usually remain unchanged until maturity. Interest-bearing investments are always linked to current interest rates. In essence, they cannot pay interest rates high enough to beat inflation over time, unless they are high-risk instruments such as junk bonds.

Most interest-bearing securities are rated AAA or BB, and are awarded by one of the major rating agencies such as Standard & Poor’s (S&P). If the rating drops after the security is issued, this may indicate that the issuer will default. A significant drop in revenue, profit or liquidity may be another warning sign. Of course, in many cases, these changes will result in lower ratings.

Dividends

Dividends are a kind of cash compensation to equity investors. They represent the portion of the company’s earnings that is transferred to shareholders, usually monthly or quarterly.

Dividend income is similar to interest income in that it is usually paid at a prescribed interest rate within a prescribed period of time. But dividends are only paid to stocks or mutual funds that invest in stocks; however, not all stocks pay dividends. Generally speaking, only established companies will pay dividends, and small-cap companies usually keep cash for future development.

Both common stock and preferred stock pay dividends, although preferred stocks usually have a higher dividend yield than common stocks. Dividends can also be ordinary, taxed as ordinary income, or eligible, taxed as long-term capital gains. In most cases, the company does not need to pay dividends, at least for ordinary shares. Since dividends are a function of a company’s income, poor cash flow or profit margins may indicate an imminent reduction or non-payment of dividends to shareholders.

Dividend yields will vary according to the type of securities paid; ordinary stock dividends tend to fluctuate with the company’s current profitability, while preferred stock dividends are usually linked to interest rates. Because they are considered riskier investments than bonds, preferred stocks tend to have higher yields than CDs or most types of bonds, with the exception of junk bonds.

Capital gains

Capital gains represent the appreciation of a security or investment since the time of purchase. These gains can be long-term or short-term, depending on whether the instruments sold are held for more than a year. Both stocks and fixed income securities can generate gains (or losses). However, although the price of fixed-income securities on the secondary market may appreciate, their main purpose is to pay current interest or dividends, while stocks and real estate provide investors with most of the returns in the form of capital gains.

Historically, the return on stocks and real estate is the only return on investment that exceeds inflation over time, which is one of their main advantages. Of course, the market develops in two directions, and any profitable securities or investment may also lead to losses. The rise and fall of stocks are related to the overall market and corporate performance.

Tax advantage

Several types of investments will generate various tax incentives. Due to consumption allowances, income generated from working rights in oil and gas leases may be tax-free by 15%. Limited partnerships usually invest in real estate or oil and gas, which can be passed on through passive income, which is income generated from partnership activities that investors do not actively participate in the management. Passive income can be offset by passive losses, which are usually expenses associated with operating partnership income-generating activities.

Total return

Of course, many types of investments provide more than one type of return on investment. Common shares can provide dividends and capital gains. In addition to interest or dividend income, fixed income securities can also provide capital gains, and partnerships can provide any or all of the above forms of income on the basis of tax incentives. The total return is calculated by adding capital gains (or minus capital losses) to dividends or interest income, taking into account any tax savings.

Bottom line

Different types of investments will bring different types of returns. Some pay income in the form of interest or dividends, while others provide the potential for capital appreciation. Nevertheless, in addition to current income or capital gains, others also offer tax incentives. All these factors together constitute the total return of an investment.

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