If you’re new to investing it’s easy to become confused with the various terms. Equity has multiple different meanings which makes it even more difficult. When it comes to pinning down a clear and simple definition of the word, it’s not all that easy.
But if you ignore equity because you don’t quite understand it you could be damaging your future wealth. But before you throw all of your money into equity, it is crucial that you understand the basics as any misinterpretations could be damaging.
Here we break down equity, taking a look at its different forms and how it works.
Equity basics
When we use the word equity in investments we’ll usually use it when referring to a person’s ownership of a stake in a business. Generally in finance, a person’s equity is basically their ownership in a product or business after all debts are taken into account or paid off, this idea stems from the accounting equation:
Equity = Assets – Liabilities
For example, a house with no mortgage can be considered your equity because at any point you can readily sell the property with no debt in between the you and sale. If you do have a mortgage, your equity is the amount you would receive after you have sold the property and have paid off your mortgage.
Types of equity
When investing there are three basic types of equity; common stock, preferred shares, and warrants.
Common stock represents a level of ownership in a corporation, stockholders will receive dividends (payments) on any capital gains (profit) made, based on the number of shares they hold.
Preferred shares are stock in a business that have a defined dividend. That means in most cases the business has to pay those dividends to the holders of preferred shares.
Warrants are a type of share that guarantees the individual to be able to buy or sell at a particular price in the future. These are generally issued by the given company.
In 1993 the first exchange traded fund (ETF) was launched and was an equity fund, a basket of stocks that reflected an index. An equity ETF is made up of the companies that are within a particular index. For example, if you had a FTSE100 ETF, the companies would include Marks and Spencer and BP.
Investment
If you’re looking to invest, stocks, fixed-income (bonds) and cash equivalents are the three principal asset classes that are usually considered. These will be used in your portfolio to help plan a structure and desired risk and return profile.
When investing, equity is often referred to as a ‘risky asset’. This risk is calculated by how different the price of a particular security (stock or fund) is from the average return. Investors consider anything above or below that average as risk. Equity doesn’t always have a concrete price which can make it difficult to calculate, but because of this an equity investment often carries a premium, which means dividends will be higher in recognition of the risk that has been taken.
When investing portfolios will often be built of a range of different asset classes to balance the risk and return. Equity would be considered a driver of returns within a portfolio and might be balanced out with bonds to ensure if equity markets suffered your portfolio would be cushioned.
At Moneyfarm we have 12 model portfolios that your investment portfolio could be based on. These contain a diverse range of asset classes and geographies and each portfolio is created based on a target risk level and investment level.
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