Understanding Your Investments
Investing in something you do not understand adds an avoidable risk to your portfolio. It can also have a negative effect on your portfolio construction. So, let’s take a comprehensive look at some of the most common income producing investments.
Real Estate Investment Trust
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income producing real estate. A REIT invests in income-paying assets and then distributes that income to its shareholders as dividends
To qualify as a REIT, a company must obtain at least 75 percent of gross income from rent, mortgage interest, gains from sale of properties, and dividends from other REITs and distribute 90 percent of its taxable income to shareholders.
REITS can either be publicly or privately traded. A publicly-traded REIT will be registered with the SEC and will trade on an exchange like a stock.
Because their shares do not trade on national stock exchange, private REITs are not required to register with the SEC and can generally can only be sold to institutional investors. If you are able to purchase a private REIT, you must go through a financial advisor. But keep in mind, non-traded REITs are an illiquid investment because you most likely cannot sell your shares until either the REIT trades on an exchange or it liquidates its assets.
The benefits to investing in REITs is that they can provide income, diversification, and long-term capital appreciation. But like mutual funds, they do have management fees.
Preferred stocks have characteristics of both common stocks and bonds. Like common stocks, preferred stocks trade on an exchange. However, unlike a common stock, preferred shares rarely come with voting rights. They can also be called back (or repurchased) by the company at a predetermined time.
Preferred shares may also be convertible meaning that they can be converted into a set number of common shares at a set price
Preferred stocks function similarly to bonds. They have a par value that has an inverse relationship to interest rates. But unlike bonds, they do not come with a defined time period. Unless the company repurchases or calls the shares back, they can be held indefinitely.
Investors are also guaranteed a fix dividend at a regular interval. It is this income that appeals to many investors. Preferred shares provide steady income and usually offer better payments than bonds or common stock dividends.
However, this comes with a tradeoff. Because preferred shares pay at a consistent rate, the stock price tends to remain stable leaving little opportunity for large capital gains.
Preferred shareholders have a higher claim to distributions and must receive interest or dividends before common shareholders. If a company offers cumulative preferred shares, they must pay preferred shareholders first before they pay dividend to common stockholders if they miss a dividend payment. Preferred shareholders also have higher claim order on assets if a company becomes insolvent.
Very few companies offer preferred shares. Typically, they are offered by banks, insurance companies, utilities, and REITs.
Covered calls can also be used to help investors generate consistent income. A call is an option contract that gives its buyer the right to buy a specified number of shares of a underlying asset (usually a stock or ETF) at a specified (strike) price on or before the designated expiration date of the contract.
Although call buyers have rights, call sellers have obligations. They are obligated to sell their shares at the strike price on or before the contract’s expiration. The defining feature of a covered call is that you own shares of the underlying asset. In other words, covered calls allow you to use shares that you own to generate income. This can be a particularly powerful strategy of the underlying stock also pays a dividend.
The income from a covered call also offers you an efficient way to hedge some the risk of the stocks you hold and provides a boost to your return when you sell the stock. However, because covered calls lock in a sell price (the strike price), they can offer limited potential for gain and will not allow you to benefit if the stock has a rapid increase in price.
Moreover, because you will own the underlying asset, the biggest risk is stock ownership is the biggest risk. Covered calls are best used on stocks from financially healthy companies.
Options trade on an exchange just like stocks. But they are priced differently. Options are derivatives; they derive their value from the underlying asset. The amount you are paid is called option premium.
Understanding each investment in your portfolio – how it’s structured as well as what benefits and risks it offers you, will help you to become a more confident and successful investor.