How Will Your Investment Make Money?

You have saved and sacrificed for two years, working overtime to accumulate enough money to start investing outside of your retirement accounts. Your new broker spent the afternoon with you explaining the various investment options in detail and making your head spin.

Following several hypothetical scenarios in which your broker explained the potential returns that you could expect to receive in each case, you decided to buy some stock in a local company that you’re somewhat familiar with.

You drive away from their office thinking, “What will I get out of this, and how will I get it?”

Interest

The investor receives interest income for lending their principal to the borrower or issuer of the debt instrument. The following types of investments provide this type of income:

  • Securities with a fixed income, such as CDs and bonds. Rates of interest are usually preset and last until the security matures or is called or put.
  • Checking accounts, savings accounts, and money market accounts are in demand. Depository institutions pay interest to depositors for parking their cash in accounts.
  • Annuities that pay a fixed rate of interest until maturity, are tax-deferred.
  • Mortgages are financed by the seller, whereby the seller charges an agreed-upon interest rate on the principal loaned to the buyer.
  • Investing in the above vehicles through mutual funds.

Interest is not paid by any form of equity. Each of these debt instruments pays a set interest rate. According to the terms of the investment, this rate is usually fixed, but it can also vary.

Rates for demand deposit accounts tend to fluctuate, depending on changes in interest rates, while rates for bonds, certificates of deposit, and fixed annuities generally remain constant. Unless they are high-risk instruments such as junk bonds, interest-bearing investments are always linked to current interest rates and cannot, by nature, provide rates high enough to beat inflation over time.

One of the major rating agencies, like Standard and Poor’s (S&P), typically assigns an interest-bearing security rating, such as AAA or BB. After security is issued, a decline in this rating could be an indication that the issuer may default. An apparent drop in revenue, profit, or liquidity could also be a warning sign. As a result, in many cases, the rating will be lowered.

Dividends

Equity investors receive dividends as a form of cash compensation. It is the portion of the company’s earnings which is distributed to the shareholders, usually either on a quarterly or monthly basis.

Dividends are similar to interest income in that they are paid at a stated rate for a set period of time. Yet dividends can only be paid on stocks or mutual funds that invest in stocks; however, not all stocks pay dividends. Generally, only large corporations pay dividends, while small companies usually retain their cash for growth.

Both common and preferred stocks pay dividends, although the preferred stock dividend rate is usually higher than the common stock dividend rate. As well as ordinary dividends, there are also qualified dividends, which are taxed as long-term capital gains

A company’s common stock is not required to pay dividends in the majority of cases. Poor cashflow or profit margins can be a sign that dividend payments will be reduced or stopped altogether, as dividends are a function of corporate revenue.

Dividend yields may vary depending upon the type of security on which they are paid; common stock dividends are typically influenced by a company’s profitability, while preferred stock dividends are usually influenced by interest rates. Due to their higher risk than bonds, preferred stocks tend to have a higher yield than CDs and most types of bonds, except maybe junk bonds.

Capital Gains

A capital gain is an increase in the value of a security or investment from the time it was purchased. Long-term gains can come from selling instruments held for more than a year or short-term gains from selling new instruments. Stocks and bonds can both post gains (or losses). 

Even though fixed income securities can appreciate in value on the secondary market, their primary function is to pay current interest or dividends, while stocks and real estate usually reward investors with capital gains.

In the past, only stocks and real estate have consistently outperformed inflation in terms of investment returns, making them attractive investments. A security or investment that can post a gain can also post a loss, since the markets move in both directions. The value of equities rises and falls with the market overall as well as with corporate performance.

Tax Advantages

Tax-advantaged income comes from a few different types of investment. Depletion allowances allow working interests in oil and gas leases to generate revenues that are 15% tax-free. 

Passive income, which is income from partnership activities that the investor does not actively manage, can be passed through limited partnerships, which generally invest in real estate or oil and gas. The partnership can write off passive income as well as passive losses, which are typically expenses associated with operating its income-generating activities.

Total Return

There are many types of investments that provide more than one type of investment return. A stock can provide a dividend as well as a capital gain. In addition to interest or dividend income, fixed-income securities can also provide capital gains, and partnerships can earn any or all of the above forms of income on a tax-advantaged basis. Tax savings are included in total return calculations by adding capital gains (or subtracting capital losses) to dividend and interest income.

Final Words

Returns on investments vary depending on the type. In some cases, income is provided through interest or dividends, while in others, capital appreciation is possible. In addition, some provide tax advantages. These factors together make up an investment’s total return.

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