An equity investment refers to the ownership of stock or shares in a corporation. A typical investor acquires equities by purchasing them on the open stock market. Companies that are listed on the stock market are publicly traded, so the purchase of equities is open to anyone with an investment account. It is also possible to own private equity, these are shares in privately owned corporations that do not trade on the open market. However, the average investor cannot easily acquire these types of investments, so this article will not go into private equity in further detail. Publicly traded stocks are commonly available in two forms: Common Shares and Preferred Shares.
Common shares are the equity investments that most people have in mind when they think of stocks. When it comes to dividend payments and liquidation proceeds, common shareholders are paid after creditors, bondholders, and preferred shareholders. Common shares do not pay dividends on a regular basis, instead payments are fully at the discretion of the company's board of directors. However, common shares do come with the right to vote for the board of directors and in other corporate affairs.
The major disadvantage to common shares is their price volatility and risk of capital loss. The share price of a publicly traded security freely floats on the stock market and can easily rise and fall on a daily basis. Investors who have low risk tolerance and cannot accept short term losses will be better served by fixed income investments.
The major advantage to common shares is their potential for capital growth. Unlike preferred shares and bonds which generally do not appreciate much beyond their purchase price, common shares can double or triple in price. Common shares also enjoy the tax advantages of dividend payments in comparison to interest payments from fixed income investments. Over the long term, common equities have historically provided greater returns than fixed income investments, albeit with more volatility.
A company does not have to offer preferred shares on the open market, and many corporations choose not to. The major difference between the two share types is that preferred shares pay dividends on a fixed basis, acting like a hybrid between fixed income investments and equities. Dividend payments to preferred shares are also higher priority than common shares, though they are still subject to approval by the company board of directors and not guaranteed. If a company goes into liquidation, payment to preferred shareholders is a higher priority than common shareholders, but only after creditors and bond holders are first paid. Preferred shares also generally do not have the right to vote on corporate matters.
The major disadvantage of preferred shares is that the share price often does not appreciate like common shares. As preferred shares behave like a hybrid of a common stock and a fixed income security, their prices often trade in a tighter range than common shares. Additionally, while preferred shares are more stable than common shares, the price can still fall. Many preferred shares have yields that are connected to an interest rate, so the share price will tend to go down if interest rates rise.
Many preferred shares (and bonds) can also be called by the issuing company. When a preferred share is called, the company can purchase it back at some previously agreed price. This feature further limits the potential trading range of the price of preferred shares.
The main advantage to preferred shares is the predictable dividend payment from the shares, combined with the tax advantages of dividend payments vs. interest income. While bonds also offer predictable payments, they are burdened with additional taxes compared to preferred shares. Depending on an investor’s tax situation, preferred shares could net significantly more return compared to bonds, though with more risk as well.
Equity Mutual Funds and Exchange Traded Funds
There are mutual funds and Exchange Traded Funds (ETF) that invest in both types of equities. One of the primary reasons for buying into a mutual fund or ETF is to create a portfolio with increased diversity and decreased volatility. Individual stocks can be very volatile and risky, but many stocks spread across different sectors and countries will generally be more stable. In this way, mutual funds and ETF’s attempt to reduce the volatility seen when owning individual equities, while still allowing for the possibility of higher returns than fixed income investments.
Of course, the lower risk and added stability of a fund or ETF also means that very high returns are less likely. Another disadvantage to mutual funds and ETF’s compared to directly owning stocks is that they have management fees. A portion of your investment is deducted in order to manage the mutual fund or ETF. This effectively lowers the return that you receive on the investments, and can even make the return negative. As a result, it is critical that all investors understand the fees that they are paying for mutual funds or ETFs, and attempt to reduce them as much as possible. Future articles will delve further into investment fees.