Investment Selector

Source: Provided by the Investor Learning Centre of Canada.(Globe&Mail)

If investing is like driving a car, then what kind of investment driver are you? The race car driver who takes big risks? The school bus driver who's content to put safety first? Or something in between?

Treasury bills
Guaranteed Investment Certificates
Canada Savings Bonds
Government Bonds
Corporate Bonds and Debentures
Preferred Shares
Common Shares
Small-cap Stock
Options
Futures

Treasury bills (T-bills) are very safe short-term investments issued by the federal government and some provinces.

Governments issue T-bills in very large denominations of $1 million or so. Banks and investment dealers break these up and sell them to investors.

You always buy a T-bill at a discount to its face value. That means you pay less than what you'll get back when the government cashes it for you. T-bills are mostly offered in terms of one month to just under one year.

You might pay $975 for a T-bill and get back $1,000 when it matures one month later. Your profit is stated as a percentage of your investment, in this case it would be about 2.56% ($25 on $975).

Even though your return on T-bills is a capital gain, the government treats the return as interest income, which is taxed at a higher rate.

Treasury bills are considered among the safest investments, especially when they have three months or less to maturity. Should you need your money before the T-bills mature, you can always sell them on the open market through an investment dealer.

The returns on T-bills are generally lower than for longer term investments. However, they are ideal investments when you can't afford to risk your money.

If you believe the stock market or bond market is going to slump, T-bills can be a good place to park your money for a short while.

Big investors with lots of cash on hand might prefer to invest in T-bills rather than put the money in the bank. This is because bank account deposits are insured to a maximum of $60,000.

Canada Savings Bonds (CSBs) are investments issued to the public by the federal government. They developed from the Victory Bonds and War Savings Certificates that helped finance Canada's war effort. After the Second World War, the Government wanted to encourage the savings habit that Victory Bonds had established, and many Canadians have bought CSBs each year since.

The federal government sells CSBs each November. You can buy them from banks and investment firms in small denominations of about $100. Some employers also offer CSBs through payroll deduction plans. Generally, only individual citizens are allowed to buy CSBs.

Specific terms of each annual CSB issue vary. Some offer compound interest (interest on interest) if you don't take out the annual interest until maturity. Others offer interest rates that rise each year you hold them.

The hallmark of the CSB is that you can cash it for full face value plus any accrued interest at any bank at any time before they mature. However, unlike marketable bonds, you can't sell your CSBs at a profit to other investors on the open market.

CSBs are safe investments because they're backed by the federal government. However, they don't pay high rates of return so aren't ideal for longer term investing because the risk is that you won't stay much ahead of inflation.

CSBs pay a modest returns compared with other bonds. But they have the advantage of being immediately cashable at their full face value, plus any interest that's collected since the last interest payment. Because of this, they make good investments for emergency funds and the cash portion of a portfolio.

When governments need to borrow they issue bonds in various denominations or face values. The face value is returned to you on the bond's future maturity date and you get paid interest in the interim.

Bonds come with face values of $1,000 or $10,000, and maturities of anywhere from one to 30 years. The interest rate the bond pays you - called the coupon -- is a fixed percentage of the face value. A $1,000 bond with a 10% coupon will pay you $100 interest per year, usually in two semi- annual $50 payments.

In most cases, you won't pay face value for a bond. You will either buy it at a discount or premium to face value. If you pay less than face value, you will make a profit when the bond matures at full face value. When added to the interest you will have received, this profit pushes up your return. This mix of interest and capital gain or loss is the bond's yield.

An attraction with bonds is that you don't have to wait until maturity to earn your full return. You can sell them in the bond market before they mature - and hopefully profit doing so. Whether you profit will mostly depend on what has happened to general interest rates since you bought the bond. If rates have come down, you will likely be able to sell the bond for more than you paid. If they've risen, however, you'll probably lose on the sale.

Say you pay face value for a $1,000, 10-year Government of Canada bond paying 10%. Two years later, you decide to sell when interest rates have dropped and similar bonds are yielding 8%. Instead of selling your bond for $1,000, you can sell it for more because it's 10% coupon is attractive. So you sell the bond for $1,085, giving you an $85 profit that pushes up your return to 14.25%.

Eight years later, the person who bought the bond will get back its $1,000 face value, leaving a loss of $85. Spread out over the bond's remaining eight years, that loss reduces the buyer's return to about 8%.

Other factors besides interest rates can affect bond prices, such as the issuer's credit rating, the term to maturity, and the bond's coupon rate.

Rising inflation is a major risk to bonds because it pushes up interest rates. And if interest rates go up, bond prices drop. If you buy a bond and then have to sell when interest rates have gone up, you will realize a lower overall return on your investment. If you hold the bond until it matures, you might not keep ahead of inflation.

Another risk is called re-investment risk. You might be satisfied with the interest income you're earning on a bond now, but when it matures in 10 years things might be different. You might find that the yields on bonds are too low to meet your income needs. This is a concern for people in retirement.

You can counteract some of these risks buy buying bonds of staggered maturities, say 5, 10 and 15 years. When each of the bonds matures you can reinvest the money at the prevailing long-term rates.

A slight risk with bonds is that the government that issued it won't be able to pay interest or repay the face value. The risk is slight, but it should be taken into account, especially if you're buying a long- term bond of 20 or more years.

Conservative investors who want to earn income on their investments can buy government bonds and hold them to maturity. The returns on government bonds are generally better than for GICs and CSBs.

More aggressive investors buy longer term bonds if they think interest rates are going to fall. If this happens, they can sell their bonds at a profit.

Speculators buy bonds of issuers that are in financial difficulty or who are in default. They get the bonds cheap and hope to earn substantial profits if the issuer recovers and pays back interest owing and the bonds' face value. The risk, of course, is that they will lose all their money if the issuer doesn't recover.

Companies sell bonds when they want to borrow money to grow and expand. They promise to pay your money back on a future maturity date and pay interest in the meantime.

There are different kinds of corporate bonds. Some are secured by specific assets which you can seize if the company fails to pay interest or return the original principal amount when the bonds mature. Others that aren't secured are called debentures. They are merely a promise to pay you.

Corporate bonds often also have added features. You might be allowed to convert your bonds into the company's stock, or the company might have the right to buy back the bonds before they mature.

You can buy corporate bonds through an investment dealer. Usually issued in denominations of $1,000 or $10,000, they come with short and long-term maturities.

As with government bonds, a corporate bond's return - called the yield -- is made up of interest payments and any profit or loss you make when the bond matures or when you sell it on the open market. People sell bonds on the open market because you can't turn them in to the company for cash until the maturity date.

You can make a profit on a bond when you buy it for less than its face value. When it matures, the difference between your cost and the face value is your profit. This mostly happens when the interest on a bond isn't attractive to other investors. The seller has to discount the bond - from say $1,000 to $900 -- to compensate for the low rate of interest it pays. If you buy it, you'll make a $100 profit when the bond later matures at its full face value. When added to the interest payments you will already have received, this profit pushes up your rate of return.

That same bond you bought for $900 might make you a profit in another way. If you wanted to sell it before it matures, you might profit by selling it for $950. This might happen if interest rates have gone down. Since other investments aren't paying returns as high as before, you won't have to offer such a big discount to prospective buyers. So the best time to buy bonds is before interest rates go down!

Corporate bonds often come with added features. These can be advantages or disadvantages. Here are some features you might find:

The key risks of corporate bonds are that the company will go out of business and you'll lose your investment, and that interest rates will rise and you'll lose if you have to sell on the open market.

Corporate bonds are generally more risky than government bonds. Companies can only stay in business as long as they're profitable, while governments have a ready source of funds through taxes. If the company's credit rating worsens after you buy a bond, you might lose money if you sell. Investors will want to pay less for your bond to compensate for the extra risk they have to take.

Since they're riskier, corporate bonds often pay higher returns than government bonds. This is often attractive to people who need to live on income from their investments. However, it's a good idea not to put all your money in higher yielding corporate bonds because of the higher risk that you'll lose your money.

If interest rates are dropping, you can make a profit by selling your bond in addition to being paid interest. Convertible bonds - those that can be changed for a set number of company shares -- can rise sharply in value if the stock price rises high enough.

A preferred share is a special type of stock that regularly pays you a set amount of money out of the company's profits called dividends. They're called preferreds because you get preferential claim to the profits ahead of common shareholders.

Unlike common shares, preferred shares don't give you the right to share in a company's fortunes. Your rights end at getting a set amount of dividends and having a prior claim on the company's assets ahead of common shareholders if the firm goes out of business.

Only if the company misses a set number of dividend payments do preferred shareholders have a right to vote in the company's affairs. If the company earns a profit again, preferred shareholders are usually entitled to get all the missed dividend payments paid to them before common shareholders get any. Those that don't have this provision are called non-cumulative preferreds.

In many ways, preferred shares are like bonds, except that they don't have a set maturity date. They are often issued at a face value, usually $25, $50 or $100. The fixed dividend payments - mostly paid every three months - are like a bond's interest payments. And they react the same way to changes in interest rates as bonds do. If interest rates go down, preferred share prices go up, and vice versa.

The return on preferred shares is called a yield. You calculate it by working out the dividends per year as a percentage of the price you paid for the shares. If you pay $25 for a preferred that pays $1.75 in dividends per year, then your yield is 7% ($1.75 divided by $25 per share X 100 = 7%).

Preferreds also come with many features similar to bonds. Convertible preferreds let you exchange your preferreds for the company's common stock. A redeemable feature is very common and lets the company buy the preferreds back at a set price whenever it wants to. Retractable preferreds let you turn in the shares to the company at a specific price during specified times. Sinking fund issues are where the company puts aside money to buy back a number of preferreds each year.

Since preferred share prices react to swings in interest rates, you could get less than you paid for your shares if interest rates rise and you have to sell. This is because the yield on your preferreds likely won't be competitive with other investments now that rates have gone up. You will likely have to drop the price so that the fixed dividend gives prospective buyers an attractive return.

There's also the risk that the company will do badly and not have money to pay dividends. If this happens, you might also have to sell your shares at a loss. Other investors won't be interested in a preferred share that isn't paying dividends.

If the company goes bankrupt, you'll likely lose money on your preferreds, but likely less money than if you'd bought the firm's common stock. Preferreds entitle you to a set amount of money if the company goes bust. However, you'll only be paid after bond holders and other creditors have been paid, which might mean there won't be much left.

Yields on many preferred shares are higher than those of other fixed-income investments like bonds. This is because the return is less assured so the higher yield compensates you for taking on the added risk.

Since preferred prices respond in opposite directions to interest rates, you can make a profit by selling them after interest rates have gone down.

The income you get from the preferred share's dividend is taxed less heavily than interest on bonds, leaving you with a bigger actual return.

When you buy common shares you become a part owner of the company. You will share in the profits of the company if it does well, either by seeing the value of your shares rise, by being paid dividends out of the firm's profit, or both. If the business performs badly, you probably won't get any dividends and the value of your shares will drop.

Companies have two basic choices when they want to raise money. They can borrow or they can sell ownership or equity in the business to investors. Companies sell shares to investors in what's called an initial public offering (IPO). If the company needs to sell more shares later to raise cash, it's called a secondary offering.

After a company has sold shares to investors the shares may be listed on a secondary market such as a stock exchange. Trading of shares on a stock exchange is between investors and the company doesn't see any of the money.

The price you pay for shares is essentially set by supply and demand forces. The more people who want the shares, the higher the price will be. Ideally, you want to buy a stock that is going to be in high demand after you buy it.

There are many reasons why a stock might be in high demand. The most important is the company's ability to make bigger profits. As a shareholder, you have the right to share in the company's profits. The more money the company has left after it has paid all its debts, the more your share of the company will be worth.

Stocks are generally risky investments because if the company you invest in fails, you could lose all of your investment. When a bankrupt business is wound up, shareholders are last in line to get money out of what is left.

Some stocks, however, are more risky than others. Smaller companies that don't have track records of consistent profit growth and paying dividends are often the riskiest. Big companies that are established in their industries and which have consistently improved profits and paid dividends are usually less risky.

Many stocks are prone to rise and fall in value in the short term. If you invest in stocks and then find you need your money a year later, chances are higher that the share price will have fallen and you'll lose money on the sale.

Over the long haul, stocks as a whole have given investors higher returns than most other investments.

So if you want to get the most out of owning shares, you will usually need to own them for five, 10 or more years.

Small-cap stocks are shares of smaller companies that run a bigger risk of going bankrupt while also having the potential to earn big gains in profits if they're successful.

You'll find most small-cap stocks in Canada listed on the Vancouver Stock Exchange and The Alberta Stock Exchange. The Montreal Exchange and the Toronto Stock Exchange also list a large number of small-cap stocks.

While there are various definitions, small-caps are mostly companies where the value of all the shares owned by investors amounts to less than $500-million.

Most small-cap stocks do not pay dividends. This is because profits are plowed back into the business for it to grow. So your return on small-cap stocks is almost always through capital appreciation, seeing the value of your shares go up.

Many small-cap companies are in new or emerging industries like computer technology and medical sciences. Investors buy these if they believe the company has a good chance of developing a hot new product that will lead to big profits. Successful smaller technology companies can also be taken over by bigger companies, which can drive up the value of your shares.

In Canada, many small-cap companies are junior mining and oil & gas companies. Often these companies don't have any production. Investors buy them on the chance that they will find a major deposit which will drive up the share price.

Small-cap stocks are risky because of the uncertainty over the company's future. If a junior oil & gas firm fails to find a viable oil field, then it might go out of business and you'll lose most or all of your investment.

Just as the risks with small-cap stocks are high, so are the potential rewards if you invest in the right company. A small bio-technology firm that finds a cure for cancer could easily see its share price rocket astronomically.

Options are not securities themselves, but are contracts that let you to buy or sell a security like a stock at a set price between now and a certain future date. Options give you the ability to hedge investment risks or to earn magnified gains through what's known as leverage.

There are two types of options. Call options give you the right to buy a certain security at a set price between now and a future date. Put options give you the right to sell a certain security at a set price on or before a future date. There are many ways in which you can use options to your benefit. However, most fit into either pessimistic (bearish) or optimistic (bullish) strategies.

A common bearish strategy is called a covered put. You use this when you want to sell a stock in a few months from now but think the share price is going to drop and you'll lose money on the sale. If the stock has an option listed on it, you can buy a put option usually for a few dollars per share that gives you the right to sell your stock any time in the next few months at a price that's attractive to you.

If the price of your stock falls, you can exercise your put option and sell your shares at a higher price than they're worth on the open market. If your shares stay the same price or go up in value, you can just walk away from the put option. All you'll lose is the price you paid for the put.

A common bullish strategy is to buy a call on a stock you think is going to rise in value in the next short while. Instead of buying the stock itself, you can buy a call option if you think the price is going to rise.

If EFG stock is trading at $35, you might buy a call option that gives you the right to buy 100 shares of EFG stock for $40 in the next three months. The option contract might cost $1 per share or $100 for the 100 shares while if you bought the shares you'd have to pay $3,500.

Options are both complex and risky for the novice investor. You could lose 100% of your investment.

Used properly, options can reduce your risk. They can also let you participate in a stock for a relatively small amount of money and realize magnified potential gains.

Futures are a derivative investment. Rather than representing shares of ownership, like stocks, or a loan, like bonds, futures contracts are contractual agreements that derive their value from an underlying asset. Futures can be used to hedge certain price risks -- or to take on that risk by speculating on the future price of an asset.

Futures are an obligation to buy or sell a specific commodity -- say coffee, orange juice, corn, oil or gold -- on a set date for a predetermined price. A coffee futures contract is a bet on what way coffee prices will go. What happens to the coffee itself doesn't matter much to you as an investor if you are speculating in futures. Futures can be used to reduce risk. The classic example is the farmer who agrees to sell grain at a good price using a futures contract, thereby getting protection if the price of the grain later falls. The wheat farmer may like the price that wheat is going for today, but fears the price will be down when he or she has it harvested and ready to sell six months down the road. The farmer buys futures contracts on wheat today, locking in today's price. If the price does fall, the farmer will get today's higher price. If the price rises or stays the same, the farmer is just out the cost of buying the futures contracts. However, investors who use futures are mostly speculators. A big attraction of futures is that they offer investor the opportunity to make big returns on relatively small investments, what's called leverage. The flip side is that leverage can also lead to huge losses if misused. For example, you can buy a futures contract worth thousands of dollars with an initial payment of about 10 per cent of the total value. So if you buy a gold contract worth $30,000 (U.S.) when the precious metal is trading at $300 an ounce, your cost would be about $3,000; your leverage would be roughly $27,000. Each time the price of the gold futures contract rises by 10 cents, the value of your investment goes up by $10. If the price of gold falls 10 cents, you'll be down $10, money you'll be asked to pay immediately. If the price falls by $10, you'll have to come up with another $1000 immediately.

Futures contracts are both complex and extremely risky for the novice investor who speculates in them. Your potential losses could be unlimited if the price moves against you.

If you use futures as a speculator and the price moves the way you hope, you could earn huge returns on a relatively small investment. If you use futures instead as a hedger, to guarantee a price on a commodity, they can be used to reduce risk.