What is equity?
When companies want to raise capital, they offer a stake in the business to investors in return for funds. This stake is called equity. A company’s equity is divided into shares, and investors who buy these shares are called shareholders of the company. When you buy the shares of a listed company, their market price is determined by the demand-supply of shares. Equity in a company also defines the amount of money that the shareholders will receive once the debts have been paid off in the event of liquidation.
If investors feel the company will do well in the future, they will be willing to pay a higher price for the company’s shares and vice versa. Investors who invest in companies’ equity typically expect higher returns than debt since they take higher risks because debt holders are paid first in the event of liquidation.
What is debt?
Debt is the money borrowed by one party from the other. Companies can take debt for several purposes such as to purchase machinery, buy back shares, pay off old debt, and more. This debt can be taken in various ways such as taking loans from banks, issuing debentures, issuing commercial papers, and issuing bonds. Even governments issue treasury bills, bonds etc., which are sovereign-backed and are considered the safest form of debt investments.
Debt usually carries an interest repayment along with the principal amount. The interest rate can be fixed as well as floating. The interest rates on debt are based on the credit rating of the company and interbank offered rates in mutual funds. Investing in debt is comparatively safer as debt holders are paid off before equity shareholders. Since the risk is lower, the return on debt investments is typically lower than equity investments.
Goals, time horizon and investment suitability
Now that you have made yourself accustomed to debt and equity, let’s look at the relationship between debt and equity. Everyone has a different set of goals, such as preparing for retirement, buying a house, buying a car, or funding their children’s education. These goals don’t have to be achieved all at once but are met in different time horizons.
The time horizon to achieve the investor’s goal can be short-term (1-2 years), medium-term (3-7 years), and long-term (8+ years). Investment in debt is usually suitable for short-term goals since debt is safer with a certain return of principal and interest. Equity investment is suitable for medium and long-term goals, as the risk in equity decreases as the time horizon increases and the returns are also higher when compared to debt.
For instance, if an investor wants to save Rs. 30 lakh in 8 years for the down payment of their home, they can do so by investing Rs. 21,000 per month for 8 years with a return on investment of 10%.
Final thoughts
Typically, equity is safe in the long term but can be very volatile in the short term. Therefore, some experts recommend withdrawing your investment from equity after the 8th year and keeping the money in a debt instrument like treasury bills, debentures, or debt funds in different types of mutual fund. Debt issued by the government and companies with AAA to A credit rating is the safest form of debt.
The optimum allocation of your funds between debt and equity is dependent on many factors such as your risk appetite, the urgency of your goals, the time horizon, and more. Still, usually, it’s best to stick with debt for the short-term and equity for medium-term and long-term horizons.
