After reading the post on asset allocation, I got a mail from a reader asking me to elaborate on the terms debt and equity that we used there. Thanks K for asking.
Different kinds of investments have different risk & return tradeoff. We’ll talk about that later in this post.
But first before we learn more about selecting investment products, we also need to understand the difference between the two broad classifications of investment products: Debt and Equity.
The basic difference between debt and equity would be the ownership level. Let’s take an example where you invest in me.
If you give out some money to me and expect that I return the money along with interest that I pre promise that would be a debt investment. I’m indebted to you and promise you a return with fixed interest and on a fixed time.
In another case, you give me money at your own risk. But you trust me/hope that I’ll be a billionaire in the future and I’ll payback from my profits. The more profits I make, the more you do. If I am bankrupt, you don’t get anything back. And so you have invested in my equity. By evaluating & trusting me, you own me in a way!
However, for equity investors, you become an owner. As such, you also take on the risk of the company not being a success. Just as a small business owner has no guarantee of success with each new venture, neither is a shareholder. As a shareholder, if the company is successful, you stand to make a lot of money. On the flipside, you stand to lose a lot of money if the company is less than successful.
Equity: You can own any stock on the Stock Exchanges and you have invested in an equity product. If you invest through Mutual Funds who have schemes for equity. Even ULIPs invest in equity and so part of your Insurance buy goes to equity. The NPS also invests in equity.
Shares come in different sizes and categories. There are large, mid and small caps and there are penny stocks. As a beginner, you can invest in large and mid cap companies and only after you gain experience, you can consider investing a small portion in small caps and hot penny stocks. These are the riskiest but if handled well, give good returns. However, it needs expertise and nerves of steel.
Debt: Mutual Funds also have debt funds where you can invest. Some people may find investing in bonds simpler than investing in stocks. Your friendly neighborhood financial advisors can provide you with government bonds like NSC. Your banker provides you with Fixed Deposits and PPF accounts. You can also pick up some highly rated corporate bonds.
Then there are hybrid funds where the Mutual Funds invest a part in equity and a part in debt.
To compare debt and equity, you need to consider the risk and the reward tradeoff.
Risk and Return Tradeoff
When a batsman wants to hit sixes (and maximizing your returns per ball), he has to take the risk of getting caught on the boundary. Hitting sixes is not everybody’s cup of tea. It needs some talent and loads of practice.
Some experts tell us that the more risk you take, the better returns you get. Let’s take an example that shows that this formula may land you in trouble.
Imagine a No.11 batsman taking risk every ball and trying to hit sixes every ball. He will get out soon and the returns will be, in all probability, zero!!
So risk taking does not maximize returns.
It’s more about managing risks and maximizing returns.Bat like Sachin Tendulkar or Virat Kohli in the field of investments. They bat sensibly and not take risks just for the sake of taking risks.