Investing your finances in equities is the best option if you want your money to grow over time. However, you must remember that higher returns from equity investments come with higher risks, and portfolio diversification is a must.
If you are confused about which is the best equity investment option, this guide is for you. We have listed some of the top equity investments along with their advantages and disadvantages to make your decision easier.
What is Equity Investment?
Equity investment refers to investing in buying stocks or equity of a company and becoming a part owner of it. There are mainly two ways of earning from such investments.
One is from dividends distributed by the company you are buying stocks in, and the other is earning from the capital gains when the stock price rises above the purchase price. So, investing in equity means gaining ownership in a company and as an owner, the equity shareholder has excellent potential of earning higher returns but with higher risk.
Equity Investment vs. fixed-income investments
There are mainly two categories when it comes to investment, equity and fixed-income funds. Let us see how they are different.
Overview of the investments
Equity investment: These are investments of money into company stocks and gaining a fractional ownership in it.
Fixed-income investment: These are putting funds in fixed-income securities like bonds that generate regular income through interest and dividends while the capital amount remains intact.
Returns from the investment
Equity investment: You can expect higher returns over the long term as the equity prices keep rising due to market capitalisation. It is especially true for large-cap funds that hold stocks of large and well-established companies.
Fixed income investment: They have lower potential returns as compared to equity funds as interest rates change slowly, but they assure you a regular income stream.
Risk associated
Equity investment: These are exposed to higher risks, including systematic or market risk and unsystematic or idiosyncratic risk. Systematic risks refer to market volatility in different economic conditions, while unsystematic risks depend on the operations of individual companies you are investing in.
Fixed income investment: These are low-risk investment options. You can only face a default risk where the issuer isn’t meeting the cash flow obligations or may default on interest and principal payments. However, government-backed security doesn’t involve such default risk.
How to analyse fund performance
Equity investment: The performance of equity investments depends on the time frame. As an investor, you must carefully assess the past performance of a fund to guess its future. Consider checking the funds’ overall performance, including capital appreciation and dividends and the average price of fluctuations.
Fixed income investment: The performance of such funds depends on interest rate changes and credit quality. When interest rate increases, the value of existing bonds decreases, which affects the fund’s net asset value (total value of the fund’s assets minus its liabilities, divided by the number of outstanding shares).
The below table gives an overview of the difference between equity investment and fixed-income investment.
| Equity investment | Fixed income investment |
| Potential for higher returns | Lower returns compared to equity investment |
| Associated with significant risks, mainly market risks | Associated with fewer risks, mainly internet rate risk and credit |
| Diversified portfolio of equity investments | Diversified fixed-income holdings |
| They are highly liquid, which means you can transfer them into cash anytime | Less liquid, and you must follow a timeframe to get the money in hand |
| Actively managed by professional fund managers | No control over the fund’s portfolio, and professionals make investment decisions on your behalf |
| No regular income guarantee | Regular income guarantee in the form of interest payments, dividends, and getting back the principal amount on maturity |
| It is suitable for investors with a high-risk tolerance profile | It is suitable for investors with a low to moderate risk tolerance profile |
Types of Equity Investments
1. Common stock
Common stocks are direct equity investments where an investor holds shares in a company, earns returns from their profits, and has voting rights on corporate matters. As common stockholders, you are eligible to get dividends from companies’ recent or past earnings and receive a part of the money after the asset is liquidated.
Advantages
- Higher returns: Investors can benefit from an increase in the stock’s market price over time, mainly when the company performs well.
- Regular income: Companies often pay dividends to their common stockholders, which ensures regular income flow.
- Voting rights: Each stockholder has the right to vote on important corporate matters, like the election of board directors and the implementation of corporate strategies.
- Residual claim: If the company assets are liquidated, you can have a residual claim on the leftover money after all debts are cleared and preferred shareholders (investors who are given priority over common stockholders in dividend payments and asset liquidation) are paid.
Disadvantages
- Highly volatile: Common stock prices are highly volatile in the short term due to changing market or economic conditions.
- Risk of loss: You don’t have a guarantee of returns and might lose a part or whole of your investment when the company’s performance declines or goes bankrupt.
- Insecure income source: Dividends from common stocks aren’t guaranteed, and they can be reduced or eliminated if the company faces a financial crisis.
- Tax implications: Dividends and Capital gains are subjected to taxation in the UK.
Other forms of direct equity investments include large-cap stocks, mid-cap stocks, small-cap stocks, preferred stocks, and convertible bonds.
2. Convertible bonds
Investing into convertible bonds gives you the flexibility to get benefits of both debt and equity. These are corporate bonds that give you regular interest payments and can be converted into a predetermined number of common stock or equity shares of the issuing company.
This conversion can be done at specific times during the bond’s life and happens at the discretion of the bondholder. It usually happens on a date 40 days after the date of issue to any date fixed for redemption of the bond.
Advantages :
- Fixed interest income: These are mainly investing in bonds that generate regular interest payments, offering predictable income.
- Potential for capital appreciation: You can convert a part of the bond into shares when the company performs well, which allows you to earn higher returns due to capital appreciation in the long term.
- Balanced portfolio: As the investors get an option to convert bonds into a specific number of stocks, the portfolio remains balanced with debt and equity investments.
- Less risky: As your portfolio has both debt and equity ways, the risk gets distributed. For example, if the stock underperforms, you will still receive interest payments and the principal amount on the maturity.
- Flexible transactions: These bonds are traded on the secondary market, which means you can choose to buy or sell them before maturity.
Disadvantages:
- Lower interest rates: They offer lower interest rates compared to regular bonds due to their advantage of converting bonds into equity.
- Conversion risk: If the stock price doesn’t appreciate, you won’t get a chance of conversion, and your earnings will be much lower than the amount regular bonds could have given.
- Complexity: The terms and conditions of convertible bonds can be complex, which requires investors to have a thorough understanding and careful analysis.
3. Mutual Funds
A mutual fund is an investment tool where multiple investors pool their capital together to purchase stocks, bonds, or other assets. It is managed by professional fund managers who make the investment decision on behalf of all the investors.
The value of a mutual fund is called the net asset value which is determined by the total value of securities in a portfolio divided by the outstanding shares of the fund.
Advantages:
- Diversification: Mutual funds invest in multiple securities, allowing you to diversify the investment portfolio and reduce the risk associated with each asset.
- Professional portfolio management: These investment decisions are taken by professionals who have experience in the field and proper resources so that you can expect the best possible returns.
- Higher liquidity: Investors can buy or sell shares anytime at the fund’s Net Asset Value (NAV) at the end of each trading day, which means higher liquidity.
- Better investment options: These funds invest in large-cap stocks or high-valued equities that you alone couldn’t afford.
Disadvantages:
- Lack of control: When investing in a mutual fund, you give up your control to the fund manager, who makes all investment decisions on your behalf that may not always match your preference.
- Limited opportunities: These funds are traded only once a day when the market closes, which limits your ability to react quickly to significant market fluctuations.
- Costly fund management: Maintaining mutual funds is costly as it comes with management fees, administrative fees and other costs that reduce your overall investment return.
- Diluting overall returns: Since these funds pool investments from multiple investors, their performance is dependent on the collective performance of all the investments within the fund. It means the high-performing investments can be offset by lower ones, diluting the overall returns.
4. Exchange Traded Funds
It is an indirect equity investment fund with an objective to match the performance of a specific index. ETF contains multiple investment channels like stocks or bonds that you can buy and sell on the stock market as a single package. Thus allowing investors to diversify their portfolios and reduce risks.
For example, the FTSE 100 ETF comprises the top 100 largest companies in the UK, and when you invest in this ETF, you get exposed to all these 100 companies, which helps spread your risk and make a better investment.
Advantages:
- Instant diversification: ETFs provide you exposure to a broad range of acids within a single investment, including stocks or bonds.
- Easy to trade: These are traded on the stock market, where you can buy or sell shares any time during the day, unlike other funds that are traded once a day.
- Liquid assets: You can trade these funds any time of the trading day without delays or price fluctuations.
- Highly transparent: These are comparatively more transparent than other funds. ETFs in the UK have to disclose their holdings daily, which enables investors to understand what assets they own clearly.
Disadvantages:
- Risks associated: These are associated with little risk, like the fund price may fall below your entry point due to market fluctuations.
- Less diversification: If they are investing in specific sectors or foreign stocks, such investments might be limited to large-cap stocks due to the small group of equity available in the market index. It limits investors’ choices, lacks exposure to small-cap and mid-cap companies and reduces potential growth opportunities.
- Lower yields: ETFs pay dividends to investors, but the overall yield is low compared to high-yielding stocks or groups of stocks.
5. Real Estate Investment Trusts
REIT is a company or a group of companies that invest in properties and pay almost 90% of their profits from rental business as dividends to shareholders. They pool capital from numerous investors and provide them with higher returns without having to buy, manage, or finance any property themselves.
Advantages:
- Portfolio diversification: REITs allow investors to put their money in a wide range of real estate assets and a good mix of stocks and bonds.
- Lower entry investment: Investors willing to put money in the real estate domain don’t require billions of pounds but can buy fractional shares with the money they can afford.
- Regular income: These properties are used for rental business in the UK, and the profits made are distributed among the shareholders as dividends, ensuring regular income.
- Liquidity: You can buy or sell shares quickly, giving you the flexibility to access cash whenever needed.
- Professional management: You don’t need to spend time and resources in managing such investments, and a professional takes care of everything from property acquisition and management, to development and looking after profitable operations.
Disadvantages:
- Dividend taxes: The money you earn comes under the dividend income bracket, and you need to pay income tax for it every year to the government, reducing your overall return
- Interest rate risk: If the interest rate in the market increases, demand for properties decreases, leading to lower property values. This further negatively impacts the value of your investment.
- Little control: These investments are managed by professionals and you have no control at all over the decisions.
6. Venture Capital Funds
VC funds are private equity funds that invest in early-stage, high-potential small businesses and startups to help them grow.
These funds raise money from institutional investors and high-net-worth individuals and then invest in a portfolio of new emerging businesses with the aim of receiving significant returns. These VC investors generally ask for bigger stakes in exchange from the fund-raising companies.
Advantages:
- Better returns: They have the potential the generate higher investment returns compared to traditional ways. Promising startups can achieve exponential growth within a few years, leading to significant gains for investors when the business goes public or is acquired.
- Access to emerging markets: You get exposed to innovative and disruptive companies that support the development of the latest technologies, products and services, which makes your portfolio attractive.
- Portfolio diversification: VC funds allow investors to invest in a portfolio of startups across different industries and stages of development, potentially reducing your portfolio risk.
- Economic impact: Investing in such funds stimulates the growth of innovative companies in the UK, creating new jobs, enhancing productivity, and focusing on the economic development of the country.
Disadvantages:
- Higher risk of failure: Startups may fail in returning the invested funds due to business failure, so generating a profit is highly risky.
- Lower liquidity: These are inherently illiquid, which means your capital, once tied in the startups, stays in it for multiple years, and you cannot quickly sell or trade them whenever you want.
- Intensive involvement required: Venture Capitalists are often required to participate in different tasks of their portfolio companies actively. They need to provide strategic advice, mentor startups, and assist them in improving networking.
- Long waiting period: Your investments require you to sit for several years to make higher returns.
What are the risks associated with equity investments?
Equity investments not only have the potential for higher returns but also are associated with multiple risks. If your risk tolerance profile is good, you can invest in equities. Listed below are some of the risks associated with equity investments
Market risks
The value of equity can fluctuate over time due to changes in market conditions like economic downfall or political events, exposing you to a higher level of risks. The income from such investments is also not guaranteed and you can even get less return than your investment.
Company-specific risks
The performance of a particular company you’re investing in can be affected by its management decisions, product or service demands, financial health, etc., leading to a significant drop in stock prices.
Liquidity risk
When you are investing in stocks of small-cap or niche companies having lower trading volumes, buying or selling stocks faster can be difficult. If you are in a hurry to sell these shares at short notice, you will get back significantly less return than you invested.
Credit risk
Credit risk refers to the risk that a company will default on its debt obligations, leading to financial problems or bankruptcy. It can negatively impact the stock price of the company and dividend payouts to investors, resulting in potential losses.
There are multiple other risks like volatility risks, FX risks, interest rate risks, regulatory risks, etc.
Conclusion
Equity investments are suitable for investors with a higher risk tolerance profile. However, there are multiple other securities that you can try, like bonds that provide regular interest payments and real estate investments under REITs that offer regular dividends.
Before you start investing in equities, make sure you learn about the risks associated with each. If you aren’t comfortable with taking this amount of risk, you can consider alternatives to equity investments like savings accounts.