When you invest in a company, you expect to generate a return and grow your wealth. When you make equity investments, you do so with the expectation that they will generate returns. Those returns can be market-led or fixed — they can return a predetermined percentage, or one determined by the state of the market at the time. They can come in the form of capital gains and/or dividends.
The main benefit of equity investments is the ability to increase the value of the investment principal. Equity funds also offer the opportunity for diversification, making the overall portfolio stronger.
Equity investment categories
Shares
Shares represent partial ownership of companies — equity — and are typically traded on designated markets like the Dow-Jones. This isn’t compulsory — shares can be issued in numerous ways, including by unlisted companies, and can be traded off-market too. The potential profits are relatively high, but this can also be a relatively risky form of investment.
Share price rises and falls following the overall value of the market and the real or perceived performance and value of the company. Investing in shares can generate profit by buying low and selling high or by drawing dividends.
Mutual funds
A mutual fund is a fund that takes capital from its investors, then invests that capital on behalf of the whole group in assets like equity or bonds. An equity investment made through mutual funds will give limited exposure to any one company, instead distributing investments across a wider portfolio than most individual investors could. Because they usually result in a more diversified portfolio, price movements in individual companies usually don’t affect mutual funds as strongly. However, these investments are market-linked, and they are not completely risk-free. Rate of return is not assured either.
Futures and options
In addition to the cash market, investors can also trade equities in the derivatives market. Derivatives are financial instruments deriving their value from an underlying equity asset. Derivatives investors can invest either in futures or in options contracts.
Future and Options (F&O) contracts
These allow investors to buy or sell underlying stock at the market price but defer delivery until a predetermined future date.
Futures contracts
In a futures contract, both buyer and seller are legally obligated to execute the agreement at a specified date.
Options contracts
An option contract gives investors the right, but not the obligation to execute the agreement at the agreed price at any time during the contract.
Derivatives are dependent on the performance of the underlying equity — the stock or index they rely on for their value. An F&O investor bases their investments on their assessment of likely future changes in the market value of the underlying assets. Investors can use F&O contracts to buy or sell equities in large quantities based on relatively small quantities of margin money. These leveraged products thus have the potential to earn higher returns as compared to simple equity investments, but this opportunity comes at the cost of higher risk exposure. F&O contracts typically also have short expiry dates of around three months, making them unsuitable as the core of a long-term investment strategy.
Key risks in equity investment
Any market-led investment has an element of risk. The principal risks of equity investment include:
Market risk
Market risk involves the possibility of losses due to market factors, such as economic slowdowns. This type of risk is also known as systemic risk, being broadly dependent on the whole market system rather than any one company or industry. Market risk can be mitigated only by portfolio diversification, and then not entirely.
The upside of systemic risk is the opportunity to acquire quality stocks at reasonable valuations, potentially delivering high long term yields.
Performance risk
Equity funds invest in individual stocks, and these stocks may or may not perform according to expectations. In brief, if an investor’s assessment of market performance is flawed, there is a risk of loss rather than profit. Funds that invest in specific sectors or industries are most vulnerable to this type of risk, and the typically strategy used to mitigate the risk is diversification.
Liquidity risk
Liquidity is the availability of investments, at fair prices and in sufficient quantities. Equity investments which can be liquidated sometimes cannot be sold at a satisfactory price, especially if they must be sold quickly. This is liquidity risk, and generally it’s more of a problem for stocks which are traded in low volumes on stock exchanges. To mitigate it many mutual equity funds retain the option of investing a portion of their assets in debt and money market instruments with higher liquidity levels than equities, though equities will remain at the core of its investment strategy.
Who should invest in equities?
Equity investment is suited to the risk-tolerant investor, but equity mutual funds can both reduce the risks and improve the likely performance of an equity portfolio for less-experienced investors.