Asset classes for individual investors are growing exponentially in the past few years. From the traditional savings account which was the only traditional vehicle for regular people to park their money once upon a time, to over ten types of asset classes today, investment for the average Joe has come a long way.
Two of the broad asset classes are Equity and Fixed Income. Owing to their highly contrasting features, there is often a lot of conflict on the asset allocation between these categories of investment. Let us see how we can pick between the two.
What is Equity?
Simply put, equity is a means for investors to become a part-owner of the company. By purchasing shares, the investor is eligible to get a certain part of the company’s profit.
Should you opt for equity? It all depends on your financial profile. This profile consists of your risk tolerance, your funding capacity as well as your financial goals, among other factors. For example, a young individual who has recently entered the workforce, and does not have a lot of personal financial obligations has a better ability to take on equity investments than someone with obligations. The willingness of the individual also impacts this decision.
What is Fixed Income?
As the name suggests, Fixed Income is a type of asset class that gives you a predetermined amount of cash inflow at regular time intervals.
What are some key differences between the two?
These two asset classes have stark differences in a number of areas including but not limited to the following:
In an equity investment, as a part-owner of the company, you are eligible for a share of the company’s profits. However, in the case of Fixed Income, you are a creditor and essentially only receive what the company has borrowed from you along with interest. The performance of the company impacts the earning of the shareholder, but not that of the bondholder.
The Risk involved in equity investments is significantly larger than that of a fixed-income investment. Bondholders get higher priority in the scenario of the company going under, while equity holders have the last right.
Involvement in Decision making:
Since shareholders are part owners, they have a say in business decisions that take place. Shareholders get voting rights and make decisions related to operations, management, and other activities that impact the profit-generating ability of the company.
Equity instruments include Stocks, Mutual Funds, or Exchange Traded Funds (ETFs). Fixed Income investment can be done through a number of modes including Bonds, Government Securities, and Term Deposits.
Financial Goal Planning:
In the case of equity, since the visibility of projected earnings is less than the one in debt, for financial goal planning, one should prefer investment in debt funds. For an asset with regular income, it is easier to plan for your financial goals.
What should I opt for?
The decision about asset allocation depends on a number of factors, the most crucial being the financial risk profile of the investor. This includes a variety of determinants, such as age, financial obligations, earning and investment capacity, the requirement for liquidity in hand, volatility of the stock market among others. For example, a young investor who has little to no financial obligation with an investable surplus can skew his portfolio in favor of equity. Whereas a middle-aged individual with family responsibilities would be better off having a higher portfolio allocation in favor of fixed income.
External factors such as higher liquidity in the financial market, interest rates, tax advantages, etc., should be considered to ensure efficient portfolio allocation and maximize the gain.