Equity investments refer to money invested in a company by purchasing stocks and shares (including preferred shares). These financial securities represent a small piece of an underlying business. And the owner subsequently has a claim on any profits generated.
While most shares are traded between investors, companies often issue new shares to the investing public as a method to raise capital. This is also known as equity funding and is commonly used by unprofitable businesses that lack the sufficient cash flow to afford to take on debt.
Equity investments aren’t just limited to the stock market. Even private companies have shares that can be purchased. However, the barriers to investing in a private company are significantly higher than in a public one. That’s why it’s usually only venture capital and private equity firms that explore this region of the financial markets.
What are the benefits of equity investments?
Investing in shares can come with multiple benefits.
- Claim On Profits – Owning equity means to own a claim on earnings. Therefore, when the company makes money, so do the shareholders. And this is either reflected in an increased share price or through dividends. The latter can even be used to establish a stream of passive income that can potentially lead to a more comfortable or earlier retirement.
- Capital Gains – As previously mentioned, higher earnings mean a higher share price. As such, any capital invested today could be worth considerably more in the long run. In extreme cases, it’s possible to generate enormous gains with stock prices rising by quintuple digits.
- Voting Rights – As partial owners, shareholders have a right to vote on significant decisions at the annual general meeting (AGM), as well as other events. Each ordinary share has the same level of voting power (exceptions exist for businesses with multi-class share structures). Therefore, the more shares an investor owns, the more influence they have during votes.
- High Liquidity – Unless investing in penny stocks and small-caps, most publically traded shares have high levels of liquidity. As such, it’s possible to execute buy and sell orders instantly, injecting money in and withdrawing it with no delay.
Disadvantages of equity investments
While investing in stocks and shares can lead to substantial wealth generation, they also come with significant risks.
- Capital Depreciation – Business earnings don’t always go up. Even the world’s greatest companies today can still be disrupted by external forces, whether it be supply chain disruptions or macroeconomic policy. Companies that miss revenue and earnings targets can quickly see their share prices plummet. And investors may end up destroying wealth rather than creating it.
- Volatility – Stock prices can be exceptionally volatile, especially for smaller businesses. In the short term, the stock market is driven by mood and momentum. And even the strongest firms with robust fundamentals and growing earnings can see their valuation dip in the short run.
- Lowest Priority – Should the worst-case scenario occur and a business declares bankruptcy, equity investors are often left with nothing. That’s because suppliers, creditors, and lenders all have priority over shareholders when it comes to satisfying outstanding financial obligations. During the bankruptcy process, companies use any remaining financial resources and liquidate assets to raise as much capital as possible to satisfy their debts. And by the time everyone else has been paid, shareholders often see their investments collapse.
What’s the difference between equity and debt investments?
Equity is not the only source of capital for companies. Many times, businesses exercise the option of debt. And just like equity, it’s possible to invest in debt as well.
There are various types of debt securities to choose from. But the most common are bonds. Companies can issue bonds for public investors to buy with the promise to pay interest until the bond matures. When a bond matures, the firm then returns the principal amount.
Debt investors make their return through interest payments. And it’s not uncommon for secured bonds to be issued. This is a type of debt that has collateral. Therefore, investors would still be protected even if a company cannot repay the loan. That’s why debt investments are considered to be significantly safer than equity investments. Moreover, during a bankruptcy, bondholders have priority over shareholders when retrieving their money.
However, unlike shareholders, this increased safety has historically resulted in significantly lower returns. Debtholders also have no right to vote on corporate decisions. And furthermore, even if earnings increase, the interest rate on a bond will remain at the agreed-upon rate when the bonds were first issued.
What is an equity fund?
An equity fund, also called a stock fund, is a type of mutual fund that principally invests either publically traded stocks, private equity, or both. They are run by investment professionals with the expertise to analyse and discover lucrative opportunities within the equity market.
Investors can choose to buy shares in a mutual fund instead of picking individual stocks. While there are annual management fees, this means all investment decisions are handled by a professional. This makes it a popular method of investing among beginners who want to put their portfolios on autopilot.
The bottom line
Equity investments can unlock substantial returns for shrewd investors. However, it can be a risky business. And individuals who haven’t established a viable investment strategy or performed the necessary due diligence can very easily lose money.
Before making any investment decision, appropriate research needs to be executed to make informed decisions about the potential rewards and associated risks. For investors without the time or interest to carefully study opportunities within the market carefully, it may be wise to speak to an investment adviser.
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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.