Equity: Investment Guide

Find out all you need to know about equity as an investment. 

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An equity investment is an investment by individuals or firms usually in the form of shares, with income derived from dividends and capital gains. Shares should usually viewed as a long-term investment with high potential returns but with a high level of risk.

Equity investment is encouraged by companies because they require capital for their own growth plans or to ensure their current fund requirements are met. The investments are directly proportional to the company's profits and losses and the investor recovers their money when their shares are sold to somebody else.

Returns come in the form of capital gains and dividends. Dividends are a share of profits paid out each year by a company relative to its share price - a ratio known as a dividend yield. Investors should also pay attention to the price/earnings ratio of an investment, which is the valuation of a firm's current share price compared to its per-share earnings. 

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One of the biggest attractions of an equity investment is that they represent an opportunity for significant returns. An investor can potentially achieve much higher long-term returns from this type of investment compared to investing in a bank, for example.

Some investors use their own knowledge to cherry-pick the companies in which they wish to invest. This requires a degree of skill and those who get it right can achieve larger returns. Other investors prefer to invest in index tracking funds that simply provide the market return.

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The flip side of an equity investment representing an opportunity for high returns is that it also presents the potential for significant losses. It carries a larger risk factor than most other forms of investment, while the investor also gives up an element of control because the returns are dependent on the performance of a company or market, over which they have no control.

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Equity is viewed as a high risk investment because profits and losses are determined by factors the investor has no influence over. There are various types of risk that have to be considered with this type of investment, and they include:

  • Stock-specific risk

An event or circumstance specific to a company can result in the expected return of the investment being affected, such as the success or failure of a certain product.

  • Market risk

A fall in the stock market generally can lead to a reduction in expected return, such as the stock market crash of 1987.

  • Currency risk

If an investment is made overseas, there is always the possibility that the sterling might appreciate against the investing currency, such as when the rise of sterling against the dollar in 2004 restricted capital growth from investments in US equities.

  • Geographical risk

A country's businesses or a particular industry can be impacted by a natural disaster or 'Act of God' event, such as floods, storms and droughts.

  • Political risk

Major political change, such as the arrival of a new government with drastically different or new financial objectives, also carries significant risk for equity investment. This is because such change affects the wider economy, an example being the election of a supposedly left-leaning Labour government in 1973-74, which was cited as a contributory factor in the UK market's decline at that time.

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This form of investment is suited to investors working towards a long-term strategy with the overall goal of achieving substantial returns. Equity investing on its own is high risk, although as a small part of a diversified portfolio it may be suitable for even relatively cautious investors.

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As mentioned, there are various risk factors that will always go hand-in-hand with any equity investment, both now and in the future. What's more, events that can affect this form of investment, such as a natural disaster or a market crash, can be difficult to predict.

However, while the risk factors are a constant, so too are the potential for high returns, with company shares ready to climb as soon as the business begins to prosper. 

 

This information provided is based upon the opinion of Equilibrium and does not constitute advice. Investments can fall as well as rise.