How does it work?
Equity stands for a corporation’s own capital, as opposed to debt which has to be repaid at some point in time. This means that equity investors leave the company capital for an indefinite period. In return for this commitment, they obtain ownership of the business and decide how and by whom it is managed.
A company’s equity is split into shares, representing a fraction of its capital and giving the holder a fractional ownership interest.
The terms share, and stock is often used synonymously, which can be confusing. In principle, the word stock should be utilized in a more general context (“I am investing in the stock market”) while we talk about shares when it is about a specific company (“I own 100 Apple shares”).
How does an Equity investment make money?
The holders of a company’s shares (shareholders) are its owners. Among other things, this also gives them the right to decide how to allocate the profits earned through its activities. Once the business generates excess profits, the shareholders can receive those funds through dividends. Fundamentally, the value of every corporation is equal to the present value of all dividends it will indefinitely pay its shareholders in the future. Present value is derived by discounting the stream of future dividends, using an appropriate rate of return (discount rate).
The discount rate is the return the investor wishes to earn on the investment. Therefore, different investors may arrive at different present values for the same firm simply because they apply a different discount rate. For example, some equity investors focus a lot on dividend income. Still, even in the absence of concurrent dividend payments, equity investments can appreciate if investors’ expectations of future dividends increase. Vice versa, if an investor’s expectations decrease, the value of the stock depreciates.
How risky is this asset class?
Equity investments are considered relatively risky for two reasons. First of all, future profits and dividends are highly uncertain as they depend on the future success of the company’s business activities. Secondly, equity ranks lowest in a company’s capital structure. In the case of a bankruptcy, other stakeholders such as creditors need to be satisfied before the equity holders receive any funds. All that being said, there is still a significant difference between the riskiness of an equity investment in a large company operating in a stable industry with little debt and a small, cyclical, and highly indebted business.
Why is it important for my portfolio?
Many investors tend to shy away from equity investments due to the previously mentioned risks associated with them. This, however, is dangerous behavior too. Many studies show that equity investments generate much higher returns in the long run than investments in other asset classes such as fixed income or commodities. Equity also serves as important insurance against inflation as it represents ownership of real assets such as production facilities and intellectual property rights.
How do you approach equity investing?
The risks associated with equity investing are best tackled through diversification. If your investment is split between shares of 100 or 1000 different firms operating in different industries, even some bankruptcies won’t affect the value of your portfolio that much. We generally advise our clients to start with a well-diversified, global equity portfolio (the protein of an investor’s diet) and selectively add special building blocks if they desire (the cherry on the cake).
For the first, we use highly efficient, low-cost funds. The second can be tailored to individual preferences and needs building on our quantitative methodologies, fundamental investment research, and portfolio optimization using statistical techniques.
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