Definition of Equity Investment
Equity investment is an investment in the shares of a company that is typically traded on the stock market. The returns depend upon the performance or profits of the company and there are no fixed returns on equity investment. Equity is the money that shall be returned to the shareholders in case the company winds up after all liabilities are paid off.
Investors who have a high-risk appetite prefer equity investment over debt instruments. Since there is no fixed return on equity investment, therefore, equity investors may or may not get any dividend sometimes when the company is not performing too well or has decided to plow back the profits for growth of the business. But as it goes, higher the risk, the higher the reward, the shareholders’ money grows as well with the growth of the company, and return in the form of dividends and capital appreciation also become high.
Some equity investors invest in shares to make profits when their price goes high by selling them off. The stock price is decided by numerous factors in the stock market. The first factor is market forces like demand and supply; they have a major role in deciding the stock price, and sometimes the announcement of the company’s growth plan also leads to a rise in the share price.
Example of Equity Investment
XYZ Ltd wants to raise the capital of $20,000 out of which, 70% is to be raised through equity finance and rest through debt. Therefore, the capital that would be raised from the equity source of finance would be ($20,000 x 70%) i.e. $14,000. Now the company issues 1400 shares of $10 per share in the market. Any investor purchasing the shares of the company would be a shareholder and it is a form of equity investment.
This is just one form of equity investment; there are several other types that we will discuss in the next heading.
Types of Equity Investment
- Shares: A business unit or a company raises equity source of financing by issuing shares in the stock market. These shares are then purchased by the investors who expect their money to grow in the long term or expect a handsome return in the form of dividends.
- Equity Mutual funds: Mutual fund is a pool of investment money from multiple investors that invest in the funds as per the risk appetite of the investors. Equity mutual funds primarily invest in the shares of the company. The equity mutual funds can be a perfect choice for investors who want to have a diversified portfolio by investing in shares or stocks but do not have time and knowledge to do so.
- Futures and options: Future and options are derivatives; derivatives are financial instruments that derive their value from the underlying asset. Future and options derivative contracts let investors buy the securities at the current price and postpone the execution of the agreement at a pre-determined future date. In future contracts, both buyer and seller are legally bound to execute the agreement at the future predetermined date while in option contract investors have a right but not an obligation to execute the agreement as per the agreed price at any time during the contract.
- Arbitrage Scheme: Arbitrage scheme refers to the selling of the same type of stock in two different markets or stock exchange simultaneously. Investors reap benefits due to the difference in prices of the stock in two different markets. It is difficult for individual investors to invest in arbitrage schemes but they can always go for arbitrage mutual funds. The list covers the main types of equity investments but is not an exhaustive one.
Who Should Make Equity Investment?
There are a few points to consider for investors to decide whether they should be the one to invest in equity form of investment:
- An investor who wants to invest in equity should have a high appetite for risk. As equity investments are market-linked instruments thus there are no fixed returns.
- Investors wanting to invest in equity should gather proper market knowledge and skills, in case they cannot do so, they can always go for equity mutual funds which are managed by professional investment managers.
- As equity investments are volatile, therefore the prices can fluctuate in the short term, investors wanting to make equity investors will need to understand that they will have to hold the investment for long term to get a higher rate of return.
Risk of Equity Investment
The various risks relating to equity investment are as follows:
- Market risk: The risk of loss due to market factors, like economic slowdown or equity investment in the negatively impacted sector. This risk is also known as systemic risk, as it is mainly driven due to macro factors in the economy.
- Performance risk: If any particular stock is not performing well or up to the mark, the investors will have to bear the losses. This is called performance risk.
- Liquidity risk: The share or stock can be sold anytime at a fair price. But this also leads to a situation where due to lack of liquidity investors sell the shares at a lower price than the market price, which leads to the loss of money.
- Legislative risk: Change in the performance of the business due to legislative changes which eventually impacts the share prices due to which investors may have to bear the losses.
Some of the benefits are given below:
- Investors get the opportunity to increase the value of their money invested and that too not at the fixed rate. They get it in the form of capital gains or dividends.
- Equity investment helps investors in the diversification of their portfolio at a minimum initial investment.
- Investors also get opportunities from the company within which they have invested to increase the number of their shares in the form of right or bonus issues.
- Investors as shareholders get the ownership of the company proportionate to their shares and can exercise control accordingly.
Some of the disadvantages are given below:
- Dividend on equity investment is not fixed, sometimes investors get nothing when the company is not performing well or making a loss.
- Equity investment carries a high risk and is not good for risk-averse investors.
- Equity investors are mainly small investors who have limited ownership in the company, and cannot much impact the decision of the management.
- Equity investors only get returns when any profit is left after all the liabilities have been paid off and debt instrument interest has been provided for.
Equity investment is a very good form of investment. If an investor is looking for a diversified portfolio, a high rate of return in the long-term, and also want ownership in the form of shares, they should go for equity investments. Investors should gather proper market knowledge of equity investment before start investing but if they are unable to do so, they can invest in equity through equity mutual funds.
This is a guide to Equity Investment. Here we also discuss the definition and types of equity investment along with benefits and disadvantages. You may also have a look at the following articles to learn more –