What is the difference between investing in equities vs. fixed income?
There are two major types of investments: equities and fixed income. Both have their own advantages and disadvantages, so it’s important to understand the difference between the two before making any decisions.
What are Equities?
An equity is ownership in a company. When you invest in an equity, you’re buying shares of stock in a company, which entitles you to a portion of that company’s profits. Equity investing is riskier than fixed-income investing, but it also has the potential for higher returns.
What are Fixed Income Investments?
Fixed income refers to investments that provide a regular, predetermined stream of income. Bonds are the most common type of fixed-income investment. When you buy a bond, you’re lending money to a government or corporation for a set period of time. In return, the borrower agrees to pay you interest at a fixed rate. Bonds have a termination date and on that date, the borrower returns your principle.
Fixed-income investments are generally less risky than equity investments, but they also tend to have lower returns. For this reason, many investors choose to allocate a portion of their portfolio to both equity and fixed income. Read more in detail here about Fixed Income Investments.
When deciding how to invest your money, it’s important to consider your goals and risk tolerance. If you’re looking for long-term growth potential, equity may be the better option. However, if you’re more concerned with preserving your capital, fixed income may be a better choice. Ultimately, the best way to invest is the way that aligns with your goals and risk tolerance.
9 Key Differences between Equity & Fixed income
#1 – Ownership vs Lending
When you invest in equity, you own a piece of the company. This entitles you to a portion of the company’s profits. When you invest in fixed income, you are lending money to a government or corporation. The borrower agrees to pay you interest at a fixed rate. Then, at a predetermined date, the borrower will return your initial investment.
#2 – Risk
Equity investing is riskier than fixed-income investing but has the potential for higher returns. Fixed-income investments are less risky but have lower returns.
#3 – Returns
Equity investors seek capital appreciation, which is an increase in the value of their investment over time. Equities may also pay dividends, which can provide income. In most cases, dividends are smaller than the income that are paid to a fixed income investor. Nevertheless, an equity investor can receive both capital appreciation and dividend income.
Fixed-income investors seek current income, which is the regular interest payments they receive from their investment. Fixed income investors generally do not receive capital appreciation, or the growth in the value of their investment. In most cases, a fixed income investor receives only the income plus the return of the initial investment at a predetermined date.
#4 – Taxes
Capital gains from equity investments are taxed at a lower rate than ordinary income from fixed-income investments as long as they are held for at least 365 days. Dividend income from equities is usually taxed at a lower rate also. Income from fixed income investments are usually taxed at a person’s income-tax rate, which is higher than long-term capital gains rates.
#5 – Volatility
Equity prices can be more volatile than fixed-income prices, which means they can rise and fall more dramatically over short periods of time. If you are investing for a fixed period of time, after which you will need a lump sum of money, then a fixed income investment may be a good choice. If, however, you are investing for a long period of time without certainty about when, if ever, you may need to use the money, then equity investments are a good choice. Equities, over long periods of time, provide higher rates of return than bonds and other fixed income investments. In large part, this is due to their short-term volatility. An investor who can stomach the short-term ups and downs of equity markets can earn potentially higher returns than a fixed income investor who has the income fixed, as well as a date when they can expect the return of their initial investment.
#6 – Diversification
Fixed-income investments can help diversify a portfolio because they tend to move in the opposite direction of equities. This means that when stock prices are falling, bond prices may be rising, which can help offset some of the losses. Importantly, this is not always the case. 2022 began with both equities and bonds declining in value at the same time. A number of factors play into whether equities rise or fall over any short period of time. Fixed income investments also are affected by a number of factors. The biggest factor affecting bond prices is interest rates.
#7 – Maturity
Bonds have a maturity date, which is the date on which the bond issuer must repay the principal amount of the loan. Equities do not have a maturity date, so they can be held indefinitely. An investor who needs a lump sum of money at a certain date in the future may want to invest in a bond that comes due at that time. In the interim, the bond pays a fixed income. At that future date, the investor can rely upon the initial investment being returned to them. Fixed income investors should consider risks that include, the credit worthiness of the borrower, inflation, interest rates and more.
#8 – Accessibility
Fixed-income and equites are purchased through investment advisors, stock brokerages, mutual funds and electronically traded funds (ETFs) and notes (ETNs). Sometimes a brokerage will charge an up-front commission. However, in today’s world, the commissions should be fully disclosed and very inexpensive. The internet and preponderance of competition has driven down the costs of investing.
#9 – Bankruptcy
Another key difference between equities and bonds is that bondholders have priority over shareholders if a company goes bankrupt and is liquidated. This means that bondholders will receive their money back before shareholders. This is because bonds are a debt obligation, while shares are equity. As such, bondholders are considered creditors, while shareholders are considered owners.
#10 – Interest rates
A key difference between bonds and equities is how they are affected by rising interest rates. As interest rates go up, bond prices go down. For a fixed income investor, they will see the price of their investment decline in a rising interest rate environment. If the bond holder keeps the investment until the maturity date, they will still receive all of their initial investment back, assuming the borrower is still credit-worthy. However, if the investor purchased the fixed income in an ETF or a mutual fund, then the value of the fund will decline as interest rates increase.
Equities are not directly affected by rising interest rates in the same way that bonds are. Some equities do better than others in a rising interest rate environment. For example, equity in a company which has high debt may be more subject to rising interest rates than a company with no, or very little, debt. So the value of the equity for the highly-leveraged company could decline as interest rates rise, or at least not rise as quickly as a company with very little debt. Equities are more prone to volatility than bonds, in large part because equity investors take into consideration countless factors, including .
Are mutual funds equities or fixed income?
This is a difficult question to answer because there are different types of mutual funds. Some mutual funds invest in equities. Other mutual funds invest in bonds and other fixed-income investments. Still other mutual funds invest in both stocks and bonds, which would make them hybrid investments. Ultimately, it depends on the specific mutual fund in question.
Equity vs Fixed Income: The Bottom Line
Both equity and fixed income have a place in a well-diversified investment portfolio. Which one is right for you depends on your individual goals and risk tolerance. If you’re looking for growth potential, equity may be the better option. However, if you’re more concerned with preserving your capital, fixed income may be a better choice. Ultimately, the best way to invest is the way that aligns with your goals and risk tolerance.