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Becoming financially independent is one of the key points in most of our vision boards today. But, do you think it is possible to be so, with salary as the only income source? Well, maybe, but it will not be a cakewalk. That is where investments are noteworthy.
From young adults to veterans, investment is an aspect of every well-made financial plan. Of the various investment options, the equity and fixed-income markets are two sought-after avenues. In today’s article, let’s understand what equity and fixed-income markets are, their pros and cons, and the differences between the two.
What is an equity market?
The equity market primarily consists of stocks that give investors a part ownership in the issuing company.
When an investor invests in a stock, proportional ownership in the company is transferred. The ownership comes with voting rights, meaning the stockholder can participate in the company’s management, annual general meeting and other events to express his/her opinion.
Besides voting rights, equity holders are entitled to profits through dividends. The amount of dividend paid varies based on the company’s profits. If the company is at a loss, the equity shareholder may not receive any dividend for that period.
Another significant reason for investors to choose equity markets is the benefit of capital appreciation. The market price of shares constantly fluctuates, and when they increase, the investor’s investment value increases, too.
Pros and cons of investing in equity markets
Advantages of the equity market:
- Holding stocks for a long time can significantly appreciate the investor’s capital, leading to a high rate of return.
- Investing in stocks allows investors to become owners of public limited companies. So, when such companies grow, the investors grow, too.
- Dividends from stocks act as an additional income source for investors.
- The stock market has various sectors and industries, which gives investors the benefit of diversification. It also helps increase the investor’s knowledge and exposure to different industries.
- Shares can be easily bought and sold on stock exchanges, making them highly liquid.
Disadvantages of the equity market:
- The stock market is highly volatile and risky. Capital appreciation and capital depreciation are equally probable.
- Shareholders may not be entitled to any dividend if the management decides so. Hence, dividends are not a reliable income source.
- Stock market investments require immense skill and knowledge, besides being stressful and cumbersome.
What is a fixed-income market?
The fixed-income market consists of all those instruments providing a fixed periodic income to investors. Some investors confuse the fixed-income market to only consist of debt instruments like debentures and bonds. However, other instruments like provident funds and saving schemes also form a part of this market.
Ownership is not a part of fixed-income instruments. Investing in debentures and bonds is like lending a loan to the issuer, for which investors receive periodic interest. They also receive the principal invested, as it is, on the maturity date.
Fixed-income instruments come with a maturity period, which means investors cannot liquidate their investments until maturity unless the security allows early redemption.
Pros and cons of investing in fixed-income markets
Advantages of fixed-income markets
- They pay a fixed periodic payment, making this a dependable income source.
- The risk of capital loss is eliminated in fixed-income instruments. They help in retaining the investment value.
- Fixed-income instruments act as a balancing factor to compensate for the risks and losses in the equity market.
Disadvantages of fixed-income instruments
- Since these instruments are less risky, their returns are also lower as compared to equities.
- Interest rate risk is an inherent feature. A change in the market interest rate directly affects the value of the security.
- Credit risk is also one of the significant threats in fixed-income securities, where the issuer may default in paying interest or principal.
Differences between equity and fixed-income markets
- Equity holders are owners of the issuing company, but fixed-income instrument holders are creditors.
- With equity investments, investors participate in the company’s profits and management. Bondholders are only entitled to interest.
- Equity shareholders’ dividends vary based on the company’s profits, while bondholders receive fixed and consistent income.
- Stocks are highly volatile and risky, whereas fixed-income securities come with lower risk.
- The returns on stocks are high but unstable. On the other hand, bond returns are low but stable.
- Stocks are more liquid as compared to fixed-income instruments.
- During the company’s winding up and liquidation, bondholders are given more priority over equity shareholders.
Bottomline
Equity and fixed-income markets are two avenues offering varied benefits to investors. A popular thumb rule suggests investing in both of them according to the investor’s age and a base value of 100.
The formula 100 – investor’s age suggests the portion of investments in equities and the rest in debts. This works on the concept of investing more in equities when the investor is younger since the risk tolerance is usually high.
Does your portfolio have equities and fixed-income instruments? If not, you now know how to divide your investments. Happy investing!
FAQs
A bond is a fixed-income instrument. Bonds are issued by corporations, governments, municipalities, etc., to raise funds for operations. Bondholders are considered creditors to the issuing entity. The investment amount is treated as a loan, for which investors are paid periodic interest.
There are two types of shares:
Equity shares or ordinary shares and preference shares.
Preference shareholders get a fixed dividend, unlike equity shareholders, whose dividend is based on the company’s profits. Besides, preference shareholders get preference over equity shareholders, at the time of liquidation and dividend payments.
Shares are more exposed to the market than bonds. Hence, share prices are far more sensitive to market events, as compared to bond prices. Besides, bonds, unlike shares, involve compulsory payment of interest irrespective of the issuer’s financial position.
Interest rates and bond prices are inversely proportional. When the market interest rate rises, the existing bonds with lower interest become less attractive, because of which their value decreases. Conversely, when the market rate falls, existing bonds become more attractive and their value increases.
The choice between equity and debt depends on the investor’s preferences.
Debt is suitable for risk-averse investors expecting a stable return. Equity, on the other hand, is suitable for investors with high-risk tolerance, expecting a capital appreciation in the long run.