How stocks and dividends work
Stocks (or shares) are a foundational type of investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition. Stocks can rise or fall in value. This in turn influences activity in the stock marketStock market The collection of markets and exchanges where stocks, bonds and other securities are issued or traded.+ read full definition overall.
Understanding how stocks work and the potential risks or dividends from stocks, will help you as you develop your investing plan.
On this page we answer:
- What is a stock?
- What are the risks of investing in stocks?
- How can you make money investing in stocks?
- What is dividend investing?
- What is stock volatility?
- How can you manage stock volatility?
- How will your stock earnings be taxed?
What is a stock?
A stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition is an investment that gives you part ownership, or a shareShare A piece of ownership in a company. A share does not give you direct control over the company’s daily operations. But it does let you get a share of profits if the company pays dividends.+ read full definition, in a company. Stocks (or shares) are one of the three main assetAsset Something of value that a company or an individual owns or controls. Examples: buildings, equipment, property, a car, investments, or cash. Can also include patents, trademarks and other forms of intellectual property.+ read full definition classes:
- stocks or equitiesEquities Another word for investments in the stock market.+ read full definition
- fixed incomeFixed income An investment that pays regular income to you. Examples: Guaranteed Investment Certificates, Canada Savings Bonds and types of other bonds.+ read full definition securities such as bonds
- cash or cash equivalents such as guaranteed investment certificates.
A publicly traded company can have tens of millions of shares — owned by people around the world called stockholders or shareholders. Shareholders do not have direct control over the company’s daily operations. But owning shares in a company often provides you with voting rights in some of the company’s business decisions.
There are two main types of stock: common and preferred. They differ in terms of their volatilityVolatility The rate at which the price of a security increases or decreases for a given set of returns. A stock price that changes quickly and by a lot is more volatile. Volatility can be measured using standard deviation and beta.+ read full definition and what shareholders are entitled to.
- Common stockCommon stock See Common Share.+ read full definition
The majority of stocks sold are common stocks. Common stock offers the potential for growth through rising share prices and increasing dividends. Prices of common stock tend to be more volatile than the prices of preferred stock.
Common shareholders are generally entitled to:
- DividendDividend Part of a company’s profits that it pays to shareholders in proportion to the total number of shares held. The Board of Directors sets the amount. For common shares, the amount varies. It may skip dividends if business is poor or the directors invest money in things like new equipment or buildings.+ read full definition payments – but there’s no guarantee you’ll receive dividends, and no guaranteed amount if you do.
- Vote at shareholders meetings – shareholders typically get one vote per share. They can vote to elect company directors and on other corporate matters at the annual shareholderShareholder A person or organization that owns shares in a corporation. May also be called a investor.+ read full definition meeting, or by completing a shareholder ballot online or by mail. You have the right to vote because you’re taking a greater risk with common shares.
- Claim on the company’s assets – if the company goes bankrupt and is liquidated. But common shareholders get paid last — behind taxTax A fee the government charges on income, property, and sales. The money goes to finance government programs and other costs.+ read full definition authorities, employees, creditors and preferred shareholders.
- Preferred stock
Preferred stock offers regular income through fixed dividends and the potential for growth through rising share prices. The prices of preferred stock tend to be more stable than the prices of common stock. Preferred stock may offer features such as the right to redeem your shares at certain times or to convert your shares to common shares at a certain price — known as convertibleConvertible An investment like bonds or preferred shares that may be exchanged, usually for common stock of the same company.+ read full definition preferred shares.
However, preferred stock doesn’t normally come with voting rights.
Preferred shareholders are generally entitled to:
- Fixed dividend payments –that usually don’t change, whether or not the company does well. Dividends are paid to preferred shareholders before any dividends are paid to common shareholders. If the company can’t pay the dividend on preferred shares in a year, it may carry it forward and pay it in future years.
- Claim on company assets –preferred shareholders have priority over common shareholders if the company goes bankrupt and is liquidated.
Stocks are bought and sold through stock exchanges and other marketplaces. Learn more about factors that can affect stock prices and how the stock market works.
What are the risks of investing in stocks?
When you investInvest To use money for the purpose of making more money by making an investment. Often involves risk.+ read full definition in a stock, you could lose all of your money – in some cases, more than you invested. Before you buy a stock, understand the risks and decide if they are risks you are comfortable taking.
There are two main risks of investing in stocks:
- Returns are not guaranteed –As with any investment, there’s no guarantee you’ll make money on a stock at any given point in time. Although a number of things can help you assess a stock, no one can predict exactly how a stock will perform in the future.
- You may lose money –Stock prices can change often and for many reasons. You have to be comfortable with the risk that you might lose all of your money when you buy and sell stocks, especially if you’re not planning to invest for the long termTerm The period of time that a contract covers. Also, the period of time that an investment pays a set rate of interest.+ read full definition.
How can you make money investing in stocks?
The value of a stock can go up or down. And it can change frequently. As an investor, if you sell a stock for more than you paid for it, you’ll have a capital gainCapital gain The money you make when you sell an investment or some other asset for more than you paid for it.+ read full definition. If you sell it for less, you’ll have a capital lossCapital loss The money you lose when you sell an investment or some other asset for less than you paid for it.+ read full definition.
Many factors can affect the price of a stock including:
- the size, profitability and financial stability of the company.
- economic factors such as interest rates.
- investor sentiment.
The other way a to make money from stocks is through dividends. A dividend is a payment to shareholders from the company. The money comes from the company’s profitsProfits A financial gain for a person or company. Equals the money left over after you subtract your costs from the money you made.+ read full definition, and the amount you receive typically depends on the number of shares owned, the share class (type of share), and when the shares were owned.
Common and preferred shares may receive dividends. However, preferred shareholders usually receive dividends on a fixed schedule and benefitBenefit Money, goods, or services that you get from your workplace or from a government program such as the Canada Pension Plan.+ read full definition from additional rights, such as the right to receive dividends before common shareholders.
What is dividend investing?
Dividend investing generates passive income. You receive regular payments which you can use for daily expenses or to reinvest to buy more shares. Depending on your tax situation, you may pay less tax on dividend income compared to income from interest or capital gains. Federal and provincial tax credits may also lower the amount subject to tax.
Many larger, established companies try to pay regular dividends. Others may not pay a dividend if they choose to reinvest their earningsEarnings For companies, it’s the money they make and share with their shareholders. For investors, it’s the money they make from their investments.+ read full definition in the company, profits are low, or the company loses money. And some companies may choose not to pay dividends. This decision is made by a company’s board of directors.
The dividend you receive is based on the number of shares you own, and on the company’s profits. Dividends are most often paid on a quarterly basis as a cash payment to shareholders. Sometimes they are paid in stock. You may be able to arrange to have your cash dividends reinvested in stock through a dividend reinvestment plan (DRIP)Dividend reinvestment plan (DRIP) The automatic reinvestment of shareholder dividends in more shares of the company’s stock.+ read full definition.
A dividend reinvestment plan lets you automatically reinvest dividends by buying more shares without paying a commission. DRIPs tend to be offered by larger, well-established companies with a history of paying dividends. Check a company’s website to find out if they offer a DRIP. You can enrol yourself in the plan through the company’s transfer agent, or your investment firm may be able to do this for you.
There are three main advantages of a dividend reinvestment plan:
- You can usually buy the extra shares for less than their current price.
- You can avoid paying a commission.
- You can reinvest small amounts, often as little as $10.
Dividend yieldDividend yield A ratio that shows annual dividend rate expressed as a percentage of the current market price of a stock. To calculate, you divide the total dividends you get in a year by the price of each share that you own.+ read full definition is a ratio that is calculated by dividing the total annual dividend by the current market priceMarket price The amount you must pay to buy one unit or one share of an investment. The market price can change from day to day or even minute to minute.+ read full definition of the stock. The dividend yieldYield Your yearly return on an investment. It’s often stated as a percentage, such as 5%. With stocks, yield can be your yearly income from dividends. With bonds, it’s the interest you get.+ read full definition is useful when comparing the potential dividend returns of different stocks.
What are the risks of dividend investing?
Dividends are not guaranteed. A company may decide to delay, reduce, or eliminate dividends at any time. A company’s board of directors decides whether to declare a dividend which may depend on many factors, including the financial strength of the company. It can be a one-time event or paid on a monthly, quarterly or annual basis. Some companies may choose not to declare dividends.
Stocks, like all investments, come with risks. Large companies with a strong track record of offering dividends can still be affected by global events, industry-specific news or stock market volatility. If a company experiences financial difficulty or decides to reinvest profits back into its operations, dividends could be impacted.
What is stock volatility?
There are always ups and downs in the stock market. This is normal since the stock market is influenced by many economic and human factors. The potential for investments to increase in value is what motivates investors to buy.
If a stock price changes quickly and by a lot, then it is considered more volatile. This makes a stock riskier — you could lose a lot if you had to sell in order to get your money out on short notice.
Volatility is measured not just in day-to-day fluctuations but in very precise ways, including:
- standard deviationStandard deviation A measure used to determine a stock’s volatility by measuring how widely its price has gone up and down in the past from its average price. More change results in a higher historic volatility.+ read full definition –measures how widely a stock’s price has gone up and down in the past from its average price. More change results in a higher historic volatility.
- betaBeta Measures how the stock is doing compared to overall stock market. A beta of 1.0 tells you that a stock has been going up and down with the overall stock market and is considered as volatile as the market. A stock with a beta between 0.0 and 1.0 has smaller ups and downs and may…+ read full definition –measures how the stock is doing compared to a given benchmarkBenchmark A yardstick that you can use to measure the performance of an investment. Example: a stock market index may be a benchmark you can use to compare how well your own stocks are doing.+ read full definition, such as the S&P TSX Composite Index. A beta of 1.0 tells you that a stock has been going up and down with the overall stock market. A stock with a beta between 0.0 and 1.0 has smaller ups and downs. A beta greater than 1.0 has wider price swings. Stocks with a negative beta are moving opposite to the indexIndex A benchmark or yardstick that lets you measure the performance of a stock market, part of a stock market or a single investment. Examples: S&P/TSX, S&P/TSX Canadian Bond Index.+ read full definition.
How can you manage stock volatility?
While it’s difficult to predict market volatility in investing, there are ways you can mitigate it.
- Hold a diversified stock portfolioPortfolio All the different investments that an individual or organization holds. May include stocks, bonds and mutual funds.+ read full definition
You may be able to reduce the ups and downs in the total value of your stock portfolio by buying stocks from companies with different features:
- Type of industry –While companies in one industry may struggle, companies in another industry may be doing well. For example, energy stocks might slump while technology stocks are rising.
- Company size – You can reduce your overall risk by owning stock in companies of different sizes.
- Type of stock –Preferred shares tend to offer lower risk and returns than common shares. But they pay a fixed dividend, unlike common shares. You may want to choose both for your portfolio.
Before you decide on a stock or a portfolio of stocks, figure out how it fits with the rest of the investments you own, your overall financial goals and your tolerance for risk. Learn more about the risks of investing and how diversification can help reduce your overall risk.
- Invest for the long term
The stock market is subject to short-term fluctuations, as well as bear markets. But over the long term, the stock market has historically performed well. If you buy stock with money that you may need soon, you may be forced to sell in a period when a stock’s price is down.
- Don’t try to time the market
Trying to time the market can be a risky strategy. Stocks are long-term investments with many short-term fluctuations in price. If you try to ‘beat the market’ by making frequent trades, this can result in accumulating more fees over time due to the frequent transactions. Instead of focusing on short term headlines, focus on your long-term goals by tracking your investment progress, including the returns on your investments, over time. Make a plan to review your portfolio at a specific time (or times) of the year, perhaps with an advisor, and make changes if it makes sense for your goals.
- Get advice if you’re not a knowledgeable investor
It’s always risky to invest when you don’t understand how the stock market works, what makes a stock’s price rise or fall, or how an investment or investment strategy works. The more you know, the more you can lower this risk. If you don’t feel comfortable with your level of knowledge, a qualified advisor can help you choose stocks and other investments that meet your goals and tolerance for risk.
- Be careful about buying private stock
Some companies keep their stock in private hands instead of trading their stock publicly on the stock market. The stock is owned by a group of shareholders who can only sell their stock with approval from other shareholders. The shareholders set the price at which the stock can change hands.
Buying private stock is risky because:
- You may not be able to buy or sell the stock when you want to.
- You may have to make a large investment(unless you are an employee of the company).
- It may even be a scam.
- Be aware of the dangers of investing offshore
Canada’s securities and banking laws protect you by offering recourse through the courts if you feel you have been harmed in your investing. When your money goes to another country, you may lose that protection. If you’re approached about investing offshore, be cautious — it could be a scamScam When someone tries to make money by misleading or tricking another person.+ read full definition.
How will your stock earnings be taxed?
The way your stock earnings are taxed depends on whether they are held in a registered plan or in a non-registered investing accountAccount An agreement you make with a financial institution to handle your money. You can set up an account for depositing and withdrawing, earning interest, borrowing, investing, etc.+ read full definition.
Investments held inside a registered plan
Registered plans offer certain tax advantages. For example, if you hold stocks in an RRSP, RESP or RRIF, you don’t pay tax on what you earn while your money is in the plan, but withdrawals are fully taxed as income. With a TFSA, you don’t pay any tax on what you earn while your money is in the plan — or when you take it out.
Investments held outside a registered plan
Money you make on stocks held outside a registered plan is subject to tax. Dividends and capital gains are treated differently for tax purposes, which will affect your return from an investment:
- dividends –are taxable in the year you receive them, whether you get them in cash or they are reinvested for you. If you receive dividends from a Canadian company, you may be eligible for the dividend tax credit.
- capital gains –you’ll pay tax on any capital gains you realize if you sell a stock for more than what you paid for it. You only pay tax on 50% of capital gains in any year.
Dividends and capital gains from investments held outside a registered plan receive preferential tax treatment compared to investments that earn interest. Learn more about how investments are taxed.
- Stocks are a type of investment that give you part ownership in a company.
- There are two types of stock: common stock and preferred stock. They have different shareholder rights and potential for growth.
- Dividend investing is a way of generating passive income from stocks.
- Investing in stocks comes with risks, like all investments.
- There are ways to mitigate the risks of stock market volatility, including diversifying your portfolio, focusing on long-term goals, and taking caution on private or offshore investing.