Equities are the best investments for a balanced portfolio with the long-term in mind. And you have a choice: not only the sector or geographic location, but also the type of security. You have the choice of common or ordinary, preference, convertible, redeemable, and cumulative, and all the combinations in between. Common stock (US) or ordinary shares (UK) have greater risk, as they are at the bottom of the pile for repayment, if something goes wrong. But, with a prudent diversification program, this risk can be minimized.
Buy Stocks, Shares: Equity Investments
With equity investments you are buying into a company. In the US you will buy stocks. In the UK you will buy shares. Either way you are buying a share of the wealth of a company.
What Are Equities?
Buy stocks or shares?
Equities are stocks (US) or shares (UK) in a company.
Equities are the equal shares in a company, paid for by investors, that can be distributed among the holders, after all debt and preferential treatment has been offset.
But what does this actually mean?
As an ordinary shareholder (common stockholder) you own a portion of the company into which you have invested (a share of that company).
If you purchase 1,000 shares out of a total of 1,000,000 shares issued by a company, then you own 1,000/1,000,000 part of the company = 1,000th or 0.1% of the company.
You have made an investment in the future of the company, whether the fortunes are good or bad.
You can follow the rise and fall of the fortunes of the company in the investment sections of the financial newspapers. These fortunes may not necessarily be reflected in the price of the stock/share, but over time the price will tend towards the price that reflects the underlying value of the company.
These are the most commonly held investment.
Whether that be by an individual investor, a Pension Fund, an open-ended or closed-ended investment company.
What Is An Equity
Classification Of Equities
Equities are classified as
- Ordinary (common stock [US], ordinary shares [UK])
- Convertible Preference
- Redeemable Preference
- Cumulative Preference.
Common stock (ordinary shares) can be high risk, but the reward can be high return.
Investing In Common Stock
Equities Risk Reward Factors
So how do equities stack up when evaluating investment risk and rewards?
Your reward for owning a part of the company is a share of the profits.
Your risk is that, if the company falls on hard times, you will be at the end of the queue for any return on your investment.
Seniority Of Debt: Equity Standpoint
Order of payment when a company goes bust. Where in the queue does an equity holder stand?
The order in which companies are governed by law to pay off creditors, is as follows:
- Liquidation expenses
- Taxes owed to the Government
- Secured lenders and bond holders
- Unsecured lenders
- Preference stock / share holders
- Common stock (ordinary share) holders
This is the seniority of debt.
Common stock holders (ordinary share holders) are at the bottom of the pile.
This makes equities risky.
Compensatory rewards for the element of risk equities manifest
There are compensatory rewards associated with owning equities.
These rewards are:
- Dividends aka Income
The distribution of profits made by the company, on a regular basis, to equity holders.
- Capital Gain aka Capital Growth
The main reason for investing in equities.
There is a good to excellent chance that equities will deliver growth to your capital investment.
Capital Gain On Investment In An Equity
One reward for investing in equities
You undertook the analysis, and determined that the share price was at a level that you could reasonably expect, over time, to increase to a level at which you would see a reasonable return on your investment.
At a time in the future you determine the share price has increased to a level that you believe overstates the underlying value of the investment, and you divest (sell).
The difference between the original price paid, and the price at which you are able to sell, is your capital gain. Remember though that capital gains can be taxed, thus depressing the overall gain, if not offset.
Unfortunately capital gain can be negative as well as positive, and is then a capital loss. Not something you want to achieve on a regular basis.
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Equity Investment Considerations
What affects your return on investment in equities?
When investing in equities there are a number of things to consider:
Income is dependent upon each equity.
Some companies pay dividends whenever possible but some don't pay dividends at all.
When undertaking your analysis you must take this into consideration, if you require income from your investments. It does have a major impact over time.
If you reinvest your dividends, then this compounds your investment returns.
If you take dividends as a payment to supplement your wages or pension, then the actual investment will be decreased by the value of the dividend.
- Inflation Hedge
Inflation has a tendency to depress equity prices, but over time equities have and will, at least keep abreast of inflation.
- Ease of Management
Not that good.
Your investment is not only monetary, it is also time.
You need to keep a wary eye on the markets and the company. It will be necessary to recalculate the value you place on those shares, on a regular basis.
You need to be aware when it is best to divest, and take what profit you can.
- After-tax return
The tax-man can be good to you with regard to any capital gain.
The tax man calculates the level of tax you need to pay for any income capital gains produce.
This is based on the time you have held the shares, and the prevalent capital gains allowance.
It is prudent to take capital gain at tax year-end, to take advantage of capital gains tax allowance.
It is prudent to take any capital loss at the same time, as this is taken into account for any capital gains tax calculation. In essence it is added to your allowance so you can take some additional profits to compensate for the losses.
But don't fret, if you think the equity is still a good investment, then you can buy it back the next day. The only problem is the costs of sale or purchase.
As long as you stick to buying freely traded equities i.e. those on a recognised major stock exchange, then under normal circumstances, equity investments are able to be sold very easily.
Be aware that there is Stock Market risk associated with liquidity.
In times of excessive downward movements in share prices across the board, sales may be suspended for a period of time. The price that they reopen at may be significantly lower than at the time of suspension.
Preferred Stock (US), Preference Shares (UK)
Why buy preference?
Preferred stocks or preference shares have two significant advantages over ordinary equity:
- They rank ahead of ordinary equity on the basis of seniority of debt.
For this reason they are safer and less risky.
If the company goes out of business you will get paid before the owner of common stock or ordinary shares. This assumes that there is money left over, after other debt has been paid off.
- The price of preferential equity is usually more stable.
The reason for this is that preferred stock / preference share dividends are usually fixed - that is, they are paid whatever the circumstances affecting a company.
They are usually higher than those paid out on ordinary equity.
The right to convert to standard equity
Convertible preferred stock / preference share has an added advantage over just preference.
It has a right of conversion attached to it.
This means there is a right to give up the stock / shares for a certain amount of common stock / ordinary shares, on the payment of a fixed price for each, on or before a given point in time.
This allows you to take advantage of any future increase in the value of ordinary equity, whilst fixing the price you will have to pay for the purchase of that equity. This advantage extends to the end of the time period associated with the right to convert.
These are a less risky investment than ordinary equity. They also offer the same advantages as non-convertible preference shares.
The right for a company to redeem
Redeemable preference stock / shares come with the right for the company that issued them to buy them back, at a stated price.
Companies usually only do this if they have an excess of cash, or they are able to obtain capital finance at a lower rate than is inherent in the dividend payment for the preference stock / share.
Cumulative preference stock / shares have an attached obligation on a company to carry forward any unpaid dividend, to be paid at a later date, should the company miss a dividend payment.
This continues year on year until the dividend is paid.
So, if a company misses two years dividend payments, and pays a dividend in the third year, then they are obligated to pay three years dividends to cumulative preference holders.
Remember that preference dividends are usually fixed, so you can determine the payment that should eventually be paid.
For this reason they give you a (slightly) increased level of security and are therefore (slightly) less risky.
Next Investment Article
Conclusion On Equities
Equities have a not insubstantial element of risk attached to them, mainly due to the seniority of debt associated with them. This can be offset somewhat by purchasing preference stock / shares, which can have additional useful benefits attached.
Equities form the bedrock of any investment portfolio.