What Are Equity Investments

What are Equity Investments?

To date, equity investments remain one of the most viable investment opportunities when done right. An equity investment is one where an investor gets a stake in a company by purchasing shares of that company. This is done with the expectation that the shares will rise in value and the investor will get capital gains and/or dividends.

Equity investments are a popular means of diversification since they strengthen an investment portfolio’s asset allocation, however, if you want to make equity investments it’s prudent to possess several distinguishing qualities that will increase your chances of succeeding in this market.

What are the Qualities
of Successful
Equity Investors?

A key characteristic of equity investors is the ability and willingness to take on risk. From the severe stock market crash of 1929 to the crash between 1973 and 1974 (when the market lost over 40% of its value) and the 2008 crash, history has shown that equity markets may not be very well-suited to risk-averse investors who want to avoid or minimise risky investments at all costs.

With equity investments, there is no sure way to know what lies ahead and this is what makes everything risky. For instance, a year after the 2008 crash, the market saw some sharp recovery, albeit with several bouts of volatility. While investors who don’t like risky investments may have been quick to exit the equity investment market during the crash, investors with risk tolerance would have waited and thrived in the boom that followed after the crash.

The inclination
towards learning

Another important quality of good equity investors is their willingness to learn. The equities market is dynamic and your success will rely significantly on your ability to understand how equities work. For instance, one of the key things you will have to understand is what influences the price of equities. This way you can gauge how well or poorly certain equities are likely to do and this will help you make educated investment decisions. It’s also important to have the ability to learn from any mistakes you make throughout your investment journey.

The ability to invest
for the long-term

As an equity investor, you need to be able to invest for the long run. Among all the asset classes, stocks are among the most volatile and in the short-term, any substantial swings in value increase risks. However, in the long run, the same volatility is likely to help you buy when prices are low, thus increasing the value of your investment.

In most cases, investors are required to stay put during tough times as equity markets have historically moved upwards in the longer term. In other words, equity investing is about embracing market volatility and staying invested for the long term to minimise risk and increase the chances of maximising returns.

The ability to monitor
your portfolio

In addition to the challenge of selecting the right equities to invest in, many investors also struggle with maintaining a good portfolio that keeps growing. Monitoring your portfolio is important. For example, if you invest in a stock for its potential but it fails consistently, you may want to replace it. A diversified portfolio where you refine your investment strategy as you learn, and replace the stocks that underperform, in the long term will help you maintain value.

With these qualities, you increase your chances of succeeding in the equities market once you pick your investment method.

What are the Common
Ways of Investing
in Equities?

There are several avenues you can use to invest in equities. Apart from investing directly in stocks, other common ways of investing in equities include through mutual funds, index funds, investment funds and derivative products such as futures and contracts for difference (CFDs). The following is an overview of these methods.

1. Direct Investment
in Stocks

Investing directly in stocks involves buying the shares of a company in the stock market. The aim is to buy the shares at a low price and sell them at a higher price. If the value of the equity decreases below the price at which it was bought, the investor incurs a loss. When investing directly in stocks, you have the option to invest in either large-, mid-, or small-cap stocks.

Large-cap stocks are those from companies with assets featuring a higher valuation and large market capitalisation. Conversely, mid- or small-cap stocks are those from companies with lower market capitalisation. One of the biggest advantages of investing directly in stocks is that you get to actually own your equity.

2. Equity mutual
fund investments

An equity mutual fund is an investable financial vehicle that invests in equities using a pool of funds collected from many investors. This fund primarily invests its assets in listed market securities and it’s ideally meant for investors who lack the time to invest directly in shares or those who have limited knowledge of which stocks to invest in or the financial markets in general. As such, equity mutual funds make a good starting point for newbie investors who are not yet well-versed with the market.

Equity investments have several benefits but perhaps the biggest one for investors is the reduced exposure to risk and so they appeal to a wide range of investment objectives. An equity investment made through a mutual fund allocates its assets to several companies operating in various sectors, making for a well-diversified portfolio. Although mutual funds are not completely risk-free, the diversification means that the price movements of individual stocks tend to have a limited impact on the entire investment as a whole.

Mutual funds are normally actively managed by fund managers. These managers buy or sell assets within the fund in an attempt to beat the market and help investors profit. This is why it’s important to have a good fund manager when investing in an equity mutual fund since your returns will be largely dependent on a fund manager's ability to generate returns.

3. Futures and options

Equity futures and options are two derivative products that allow investors to buy or sell a specific amount of stock for a certain price at a predetermined future date. You can use futures and options contracts to earn money by speculating on price movements of the underlying stock or as a hedge for existing equity investments.

When using futures and options to capitalise on price movements, you will essentially buy or sell units of a futures or options contract by estimating whether the price of the underlying shares will go up or down in the future. Both futures and options allow you to buy or sell equities of a company by depositing just the margin, which is a fraction of the required capital outlay. This way, you have the potential to earn higher returns for relatively smaller equity and you can also open larger positions than your capital would otherwise allow.

While futures and options contracts work similarly, they have a distinct difference. With a futures contract, both the buyer and seller are legally obligated to execute the agreement at a specified date. On the other hand, an options contract gives the investor the right, but no obligation, to execute the agreement at any time during the contract’s life.

4. CFD trading

Similar to options and futures, equity CFDs mimic equity investments without you having to own the underlying equities. With CFDs, you earn by speculating on price movements.

One of the key benefits of investing in CFDs compared to buying shares directly is that with CFDs you can enjoy leverage. Just like futures and options, CFDs are traded on margin. For example, let’s say that you want to invest in Apple shares. If one share costs $1,000 and you want to buy 10, you will have to invest $10,000 ($1,000 x 10). However, using CFDs with a 5% margin requirement, you will only need to deposit $500.

Another benefit with CFD trading is the ability to sell or short the shares if the market is moving negatively, and still earn.

CFDs are a more popular derivative investment alternative to options and futures because they tend to require a smaller capital outlay and they attract lower fees. Additionally, while futures and options have short expiry dates that typically go up to three months, CFDs have no expiration dates. This means that CFDs are more suitable for potential longer-term wealth creation.

How do Equity
Investors Make Money?

Equity investments are widely known as one of the riskiest investments. However, they also have a reputation for being one of the most high-return generating asset classes. How you make money as an equity investor largely depends on the investment method you use. Some of the major ways of making money when you invest directly in shares include:

  • Profits from selling stock. Investors can make money through capital gains. Capital gains are the profit realised from the sale of stock when the market value of that stock has increased.

  • Dividends. A dividend refers to the profit which a company shares with its shareholders. If a company elects to distribute the profit, every investor will earn a specific amount on every share they own.

  • Discount on new share purchases. Existing shareholders may get discounts if they decide to buy more shares from the same company. When this happens, the investor earns a profit on the additional purchases since they do not pay the full value of their additional shares.

  • Buying back of shares. Sometimes companies decide to buy back shares from shareholders at a price higher than the market value. If an investor decides to take part in a share buy-back, they will make a profit, which is the difference between the price the company is offering and the market price.

  • Free or bonus shares. After realising exceptional profits, companies will sometimes release free or bonus shares to their shareholders. These investors will gain from the additional value provided by the free shares.

When investors choose to invest in stocks without taking ownership of the underlying asset, they capitalise on and potentially make money from market movements. From all this, it’s clear that equity investments provide several ways to potentially make some gains, but why invest in the market in the first place?

What are the Potential Benefits of Equity Investments?

Although the different ways of investing in equities have their own merits, the main benefit of an equity investment is the possibility of increasing the value of the principal amount invested. For instance, when you buy shares directly you hope that the value of the shares will increase so that you get value from capital gains and dividends. On the other hand, when you invest in the derivatives market, you speculate on price movements with the hope of gaining some value in the process. Equity investments are also a great way to diversify your portfolio as they have unique characteristics that will make for a more well-rounded collection of assets. However, while there are many potential benefits to investing in equities, like all investments there are some risks involved as well.

What are the Risks Associated with Equity Investments?

Market risk is perhaps the biggest risk that equity investments face since equity investments provide market-linked returns and their performance is influenced by market movements. Consequently, investors can lose a fraction or all of their investment due to market risk.

Market risk, which is also known as systemic risk, involves the possibility of an investment incurring losses due to market factors. It is largely dependent on macro factors and so it’s not limited to any particular industry or company. Put simply, market risk is inherent in all industries although the degree to which different sectors are affected by the risk will vary. Since market risk affects all industries, there is no way of avoiding it and diversification is, to a large extent, the best way to manage it.

When investing directly in stocks or investing through other non-derivative vehicles such as mutual funds, other types of risk that can affect equity investments include:

1. Performance risk

Sometimes stocks do not perform according to expectation and this is the essence of performance risk. This risk affects both individual stocks as well as entire sectors. For example, a sector may find itself exposed

to performance risk when several negative domestic and global factors are affecting how well the sector does. Diversification across sectors is the primary method of mitigating performance risk.

2. Currency or exchange rate risk

Currency risk, which is also referred to as exchange rate risk occurs due to shifts in the value of different international currencies. Investors who have exposure to foreign equity markets or companies that derive a significant part of their earnings from foreign markets both face exchange rate risk.

One common strategy to mitigate currency risk is through hedging which involves maintaining a cash reserve or holding highly liquid assets whose allocation can be decreased or increased to offset any unfavourable exchange rate movements.

3. Liquidity risk

Liquidity is the ease with which an investment can be sold at a fair price and in sufficient quantities when required by an investor. Equity investments with low liquidity are susceptible to liquidity risk. For instance, stocks that are traded in low volumes on stock exchanges are usually harder to trade as demand for them will likely be lower.

If you hold such shares you may have to sell them at a lower price compared to the fair market price, especially in case of an emergency. This means that the shares are prone to liquidity risk and holding more liquid types of equity investments will help to minimise the risk.

4. Socio-political risk

A company’s returns may suffer due to a country’s social, political, and legislative changes or instability. For example, a country may increase entry barriers to foreign businesses to help local industries perform better but when these barriers are lowered, the local industries’ advantage may be lost resulting in a decrease in value.

Socio-political risk exists in many industries and the best way to mitigate the risk involves diversifying across multiple industries or even across national borders.

5. Additional risk

Equity investments can also be affected by credit, inflation, and economic concentration risks. Credit risk arises when a company is unable to pay its debt and inflation risk occurs when a company’s value is diluted by rising inflation. Economic concentration risk can occur if a company’s value is too concentrated in a single entity, sector, or country. When this is the case, a drop in the value of the one factor on which the company is focused can hurt the company disproportionately.

When it comes to investing in equities through derivative products, one of the key risks is over-leveraging. Leverage is double-edged in that it can magnify losses as much as it magnifies profits. To minimise this risk it’s important to use leverage correctly.

How Much Should
You Invest in Equities?

There is no rule on how much you should invest. It all depends on several things such as the funds at your disposal and anticipated cash flow, your personal goals, home equity (real estate) and risk appetite. You should have a clear understanding of what you hope to get from investing in equities to get a better measure of how much you will need to invest.

For example, if you don’t have a lot of capital, investing in equity derivatives may be a better option than investing directly in shares since the latter only requires a fraction of the required amount. Additionally, if your end-goal is to own a stake in a company, you will have to buy shares instead of trading derivatives which don’t give you any ownership interest of the underlying asset.

Top Tips for Investing
in Equities

When investing in equities, several factors
can give you an edge in the market.

  • Time your market entry

    Unless you invest in equities using an instrument that offers the potential to make profits in both rising and falling markets, you should ideally invest when markets are low. During such times, stocks are cheaper and so you can buy more shares. This way, you increase your chances of making more gains when the share price increases.

  • Expect volatility

    Volatility is an inherent feature of equity markets and you should always be prepared for it, especially in the short run where it’s more evident. Unfavourable market movements are all part of how equity investments work and you should remain disciplined when this happens.

  • Understand the risk

    While it’s important to understand the general risk carried by equity investments, it’s also equally important to understand the risk that applies to the specific equities you are investing in. When it comes to understanding risk, it’s crucial not to be swayed by short-term performance since a longer-term outlook will yield a better understanding of the risk involved.

    You should evaluate your investment choice’s price influencers and what risks these have on your investment. If you are investing directly in shares, you should also analyse the company whose shares you want to invest in for performance sustainability and expected returns.

  • Pick well-rounded investments

    There is no easy way to pick a stock. With around 630,000 companies now being traded publicly throughout the world, there is no sure way of knowing which stocks will do well. There are always multiple factors at play when it comes to the value of equity investments and so it’s vital to pick well-rounded ones.

    Again, there is no easy way to do this except through thorough analysis. When analysing an investment keep in mind things like business models, competitive advantages, price influencers, and macroeconomic factors that have the potential to impact that investment. With more analysis, you will build your expertise and an intuitive judgement that will help you spot opportunities and any signs of danger more easily.

Are Equities a Good Investment?

Similar to other financial investments, equity investments carry some risk. However, some mindful investing characterised by patience, discipline, and sound knowledge is key to making the investments worthwhile. Investing in equities is in no way a way to get rich quick and entering the market with that mentality is a sure way to fail. Put simply, equities are a good investment, but your chances of succeeding depend on the amount of work you put into your investment, your skill, and understanding of the whole market.

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