In the context of stock market investments, equity refers to the shares in a company’s ownership. In simpler terms, it is the total amount of money that a shareholder is eligible to receive if all of a company’s debts are paid off and its assets liquidated. When an individual invests in a company’s equities, he/she becomes its partial owner.
On investment in a company’s stocks, he/she can earn profit via capital gains or stock price appreciation. Further, investing in a company’s shares also bestows an individual with a right to vote in matters pertaining to the Board of Directors.
Investing in equity shares is popular among individuals because they are high-return investment options. However, despite their potential to bear high returns, they also expose an individual’s investment portfolio to a certain degree of risk. For this reason, it is pertinent for individuals to gauge their risk appetite before deciding to invest in equity stock.
In this article
Types of Equity
Equities are market-linked investments that do not come with an assurance of bearing fixed returns. Returns on equity thus depend on the underlying asset’s performance.
Equity investments can be broadly divided into several categories, each bearing its own set of risks and rewards.
Following is a broad categorisation of equity investments –
The units of partial ownership in a company are commonly known as shares. They are traded via designated stock exchanges like the Bombay Stock Exchange or National Stock Exchange (provided that they are BSE or NSE equity shares of a listed company).
The potential returns from investing in shares can be quite substantial, with their risks being equally high.
- Equity Mutual Fund Investments
Mutual funds are investment options wherein capital from various investors is collected, pooled in and invested in various equity and debt instruments. Equity mutual funds are those options whereby at least 60% of the total assets are invested in the equity shares of different companies.
Based on their market capitalisation, equity mutual funds can be divided into the following categories.
i. Large-cap equity funds
These are funds with investment only in well-established large-cap companies and have the potential to provide stable returns at comparatively low risk.
ii. Mid-cap equity funds
These equity mutual funds are invested in the stocks of mid-cap companies. They make for the most beneficial investment options as the risk-reward ratio is well balanced with these funds.
iii. Small-cap equity funds
These are mutual funds invested in the shares of companies that have small market capitalisation and are comparatively more volatile than other categories of diversified funds.
iv. Multi-cap funds
These mutual funds come with the liberty to invest in different sectors and market capitalizations.
- Equity Futures
These are investment instruments where the investors have an obligation of purchasing or selling the underlying assets at a predetermined price and a predetermined rate. Equity futures generally come with an expiry period of three months and the settlement day is usually the last Thursday of the 3rd month.
- Equity Options
Equity options are akin to the futures where parties involved are not legally obliged to follow up on their agreement.
- Arbitrage Schemes
Arbitrage, with regards to the stock market, refers to the process of buying and selling securities in different exchanges simultaneously to profit from the difference in market price. Individuals can invest in arbitrage funds which are equity-oriented funds with primary investment in equities, debt or money market instruments and equity derivatives.
- Alternative Investment Funds
Individuals can choose to invest in equity instruments through alternative funds which comprise different pooled in investment funds that primarily invest in hedge funds, venture capital, managed future, private equity, etc.
Features of Equity
The characteristics of equities or equity shares can be tabulated as follows.
|Maturity period||As per the Companies Act 1956, a company as an entity is not eligible to purchase its own shares. The equity shares can provide capital to the company, which cannot be regained for as long as the company is functional.
Individuals who have invested in the company’s shares can only redeem their capital at the time of the company’s liquidation; after all other claims have been fulfilled.
|Shareholders’ Voting Rights||When an individual purchases the equity shares of a company, he/she becomes a real stakeholder of the organisation. The power to participate in the company’s meetings is bestowed upon such participants, and they have the right to voice their opinions on a company’s executive decisions. However, this right is exercised indirectly through a company’s Board of Directors, elected by the shareholders.|
|Income from Equity Shares||When an individual invests in a company’s shares, he/she acquires the right to claim on a company’s income. These investors can claim on the company’s residual income which is left after a preference shareholders’ dividend has been paid.
If a company has insufficient profits, equity shareholders might not earn any gains from their shares. On the other hand, they also stand a chance of earning higher dividends through capital appreciation.
|Claim on Company’s Asset||Every individual who has invested in a company’s equity shares gains an ownership claim on the company’s assets. For instance, if a company is liquidated, the equity assets are first used to fulfil the claims of preference shareholders and creditors while whatever is left belongs to the equity shareholders.|
|Limited Liability||Even though shareholders are a company’s real owners, they enjoy the advantage of limited liability. It means that their liabilities are limited only to the value of shares they have invested in. If an investor has paid the price of the share in its entirety, he/she will not be affected by the losses that the company suffers, even at the time of its liquidation.|
What are Capital Gains and Dividends?
Equity holders’ value of holdings increases when the price of the shares increases way more than what was paid for them. But that’s not the only way to gain profits by owning equities.
For instance, companies pay out dividends from their own profits to their shareholders. These periodic payments are, however, not guaranteed, but can provide major benefits when available. As an investor, you can either make the decision of reinvesting your dividends or take them as income.
Therefore it’s imperative to understand the difference between capital gains and dividends especially if you own equities. A capital gain is the difference between the price at the shares were purchased and the price for which they are sold. There are two types of capital gains, viz. long- and short-term capital gains and each have their own tax rate.
There are several benefits that an individual can enjoy by investing in equity shares. Some of them are enumerated below.
- High returns
Investing in equity shares provides high returns to investors. Shareholders have an opportunity to enjoy wealth creation, not just through dividend earnings but also through capital appreciation.
- Provides a cushion against inflation
When an individual invests in equity shares, he/she has the potential to earn high returns. The rate of returns earned is often higher than the rate of wearing down of the investor’s purchasing power due to inflation. Thus, investing in equity shares acts as a hedge against inflation.
- Ease of investment
Investing in shares is simple. Investors can avail the services of a stockbroker or financial planner to invest through various stock exchanges in a country. If an individual has set up a Demat account, he/she can buy the stocks in a few minutes. So, irrespective of whether an investor chooses to invest via NSE or BSE equity or the likes, he/she can enjoy the ease of investment.
- Diversification of investment portfolio
Investors mostly choose to stick to debt instruments since they are low-risk investment options owing to lower volatility. However, debt instruments may not always generate high returns, which is why individuals can diversify their investment portfolio by investing in equities for higher returns.
Disadvantages of Investing in Equities
Even though equity investments have their fair share of advantages, they also bear a few disadvantages. Some of them are as follows.
- High market risk
Investing in equity shares can yield returns but also exposes investors to high risk as compared to other investment options like debt instruments. An investor can risk losing his/her entire investment corpus by investing in equity shares.
- Performance-related risks
Equity investments are market-related instruments, and as a result, might not perform according to an investor’s expectations. This is known as performance-related risk and can affect individual stocks as well as stocks across a sector or sectors.
- Risk of inflation
A company’s worth can get diluted due to rising inflation and subsequently, its shares might not generate potential returns.
- Liquidity risk
Due to liquidity risk, investors might have to sell their shares at a much lower price than its fair market value. Liquidity risk arises when a company is unable to meet its debt obligations in the short-term.
- Risks arising out of social and political changes
On-going social and political issues in a country can hamper the growth of a business. For example, if a government decides to promote indigenous businesses, it might restrict the entry of foreign business in the country. If an investor has invested in home-grown businesses, he/she in this scenario will profit from better performance of his/her investments.
Who Should Consider Investing in Equities?
Equities are more suitable for investors who are willing to take a risk with their investments. Those who are constrained by the limitations in time or experience in the money-market can also lean towards equity mutual fund investments for moderate to high returns.
It is, however, crucial for investors to gauge their risk appetite before investing in the equity market to ensure that they make sound financial decisions.