As an investor, especially a new one, the sheer number of equity investment options that are available can be overwhelming. So much so, that it stops many people before they ever get started!
However, having a basic understanding of the different types of equity investments can give you the confidence to begin. The sooner you start, the faster you’ll build independent wealth, giving you the time to live out your dreams!
One of the primary reasons to budget is to establish a spending plan that allows you to save money. With savings, you can pay down debt, build an emergency fund, or grow your money by investing!
One way to put your money to work is to buy equity investments. This occurs by purchasing a company’s stock and becoming a partial owner. As an owner, you participate in the upside and downside as the stock price changes. However, you won’t pay taxes until you realize a financial gain.
Equity investments tend to get more attention than other types of assets, like bonds, because they can have higher expected rates of return. However, it’s important to realize that all investments have risks. You never know with 100% certainty whether they’ll produce a large gain or drop in value. Still, some types of equity investments tend to perform better over long periods than others.
When starting, choosing the right equity investments can seem complicated. But as you begin to understand the different types, it gets easier. In addition to that, it allows you to select the options that will help achieve your financial goals, too!
Here are 6 different types of equity investments that can help you build wealth!
One way to own part of a company is to buy its common stock. When you buy, you become a shareholder and believe that you’ll profit from the company’s future success!
As a common stockholder, you get to vote on important company issues. For example, you help elect the Board of Directors who are fiduciaries to the shareholders. The Board works with the company’s executive team to decide the company’s direction. In addition, they hold the executives accountable. If they fall short of their goals, the Board often has the power to let them go!
Also, the Board helps establish the company’s dividend policy. While not all companies pay a dividend, the Board influences the amount for the ones that do. So, if part of your plan involves relying on dividend income during the decumulation stage, you’d want to vote for Board Members that are in favor of keeping it in place!
If for some reason, the company was ever to file bankruptcy, common shareholders get paid last. They don’t receive any money until the companies’ creditors, bond holders, and preferred stock owners get made whole!
Just like common stock, preferred stock gives you ownership of a single company. But, it doesn’t give you any voting rights. Not only are you unable to elect the Board, but you can’t influence the company’s policy or direction, either.
However, preferred stocks do pay a dividend. Like bonds and other fixed income investments, you typically receive a fixed amount for each share of preferred stock that you own.
Your yield is calculated as a percentage of the preferred stock price when you buy. For example, if a stock pays a $5 dividend and you buy it at $100, then you’d receive a 5% yield. But, if the price went up to $110, your yield would fall to 4.5%.
Unlike bonds and other debt instruments, preferred stockholders are also subject to changes in the company’s preferred stock price. If it goes up, then you could sell and earn a capital gain in addition to your dividend payments!
This type of equity investment differs from others in that it has a callability feature. The issuing company has the right to redeem or buy back its shares from investors anytime they like. While this can come as a surprise, the price they pay is typically well above the company’s current market value!
In today’s environment, it’s important to note that preferred stock prices tend to change with interest rates. In periods where inflation is climbing, the Fed may raise rates which can cause the preferred share prices to fall.
Also, if for some reason the company is unable to pay the dividend to preferred shareholders, the balance accrues. However, if the company files bankruptcy, preferred stockholders won’t get paid until its creditors and bondholders are satisfied.
It’s important to realize that owning either common or preferred stock in one or a handful of companies can be risky. You’re putting your investment dollars into a limited number of baskets. Meaning your success is directly tied to those few companies’ success. If for some reason their stock price falls, your net worth will take a substantial hit, too. As a result, you might get stuck spending more time in the accumulation phase than you planned!
While there are benefits to owning stock in one company, today it’s more common to buy equity investments that allow you to own several companies, if not hundreds!
If you contribute to an employer-sponsored retirement account, the odds are good that you’re buying mutual funds. These financial vehicles pool investors’ money to buy stock in many different companies. In addition to that, many of them hold bonds, too.
When you buy a mutual fund, you’re investing in tens or hundreds of companies. Because of this, your portfolio is more diversified which reduces your risk. You’re no longer reliant on one particular company’s performance for your financial success!
Mutual funds are divided into two main categories based on the way they’re managed. Actively managed funds employ a team of workers who research different types of equity investments for you. Typically, each fund has its own set of investment criteria that they use to make decisions, too.
As an actively managed mutual fund investor, you pay for the fund’s overhead through its total expense ratio. While the fee may not seem like much, you’ll pay it regardless of whether the fund has a winning or losing year!
Most investors compare actively managed mutual funds to key benchmarks, like the S&P 500. This helps them determine if the fees they’re paying are worth the money. However, research shows that most actively managed funds don’t perform better than their benchmarks. Because of this, passively managed equity investments have become very popular!
Like mutual funds, ETFs allow investors to own a wide variety of companies by making a single equity investment. However, the difference between them has to do with the way they’re bought and sold. Mutual funds trade when the market is closed or “after-hours” whereas ETFs trade like stocks. They can be bought and sold any time the market is open!
As an investor, the most important difference is that ETFs are passively managed. Instead of having an expensive management team, office space, and other recurring costs to contend with; they replicate an index, like the S&P 500. Since no personnel or research is needed, costs are kept low. Besides that, there’s less likely to be human error, too!
Passively managed funds tend to have more favorable tax advantages than actively managed ones, too. They don’t sell or realize capital gains often which keeps investors’ tax bills low!
While the majority of ETFs are passively managed, not all of them are. Before you invest, make sure to review the fund’s summary so you know for sure.
For those pursuing early financial freedom, index funds are one of the most popular equity investments. They’re a blend of both mutual funds and ETFs. Like mutual funds, they trade when the market is closed, and like ETFs, they’re passively managed and low cost!
Index funds don’t require active management since they track an index, like the S&P 500, Russell 2000, or Wilshire 5000. Because of this, investors pay fewer fees and don’t have to worry about hidden costs. Instead, they’re left with more money invested that’s working to produce them with profits!
As an investor, it’s important to be aware of the fees that you pay. Over time, these costs can add up to a large amount of money and impact the time it takes to reach your goals!
At this point, all the previously discussed equity investments trade on public markets. At one time or another, you could look up the price, buy, and become an owner. But, it’s important to understand that not all equity investments are public!
Private equity investments are bought and sold “off-market.” This means that you won’t find them listed for sale on stock exchanges. Instead, you typically need to have ties to the company’s founder or know someone who’s raising private capital.
Most private equity investments are risky, too. Oftentimes, these companies are in the early stages of development, so they may not have a successful track record or a proof of concept. On top of that, they may not even be profitable which makes it difficult, if not impossible, to determine their value!
For instance, imagine you own shares of Microsoft. If you wanted to sell them, you could in a matter of minutes. But, selling private equity investments isn’t as easy. Due to their somewhat speculative native, it’s hard to determine the price and therefore find someone willing to buy. Not to mention, finding a buyer who’s willing to gamble on a company that may not be profitable yet, either!
Many private equity investments are not for the faint of heart. If you choose to invest in them, be sure to understand the risks and what you’re getting into. Not only that, but realize that you’re making a long-term illiquid investment, too!
For most busy professionals, the equity investments offered on Wall Street are one of the simplest ways to build wealth. While investing in them is easy, your success is completely outside of your circle of control!
To have more control and a broader asset allocation, consider buying alternative assets, like real estate. By incorporating them into your financial strategy, you’ll further reduce your risk, giving you a greater chance of achieving financial success!
Which types of equity investments are your favorite? Comment below.
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