Table Of Contents
Difference Between Equity and Fixed Income
Equity income refers to making an income by trading shares and securities on stock exchanges, which involves a high risk on return concerning price fluctuations. Fixed income refers to income earned on deposits that give fixed making like interest and are less risky.
Most financial investments can be classified into two major asset classes – equity and fixed income.
What is Equity?
Equity investment refers to buying stocks and stock-related mutual funds. Investors who invest in a stock own a share of its assets and revenues. They are convinced of the firm's growth story and believe their investments can grow as the firm grows. However, it also risks going southwards, and all its reserves will depart. For example, investors lose all the money if a company has a credit event and files for bankruptcy.
Equity can be categorized into two types – common and preferred stocks. Common stocks grant the investors the right to vote in shareholders' meetings in addition to a claim on profits. Preferential stock owners get a claim on dividends (In fact, their share is more than common stock owners), but they do not have any right to vote.
What is Fixed Income?
Fixed income is the security that gives a guaranteed result; hence it is named “FIXED INCOME.” The cash flows are paid out for a fixed amount at regular intervals and the principal at maturity. The returns might not be great, but they provide a secured one. Fixed income can be bonds – zero-coupon or coupon, corporate deposits, and may be issued by a corporation or a sovereign entity – government or municipality.
The maturity for these can range from 3 months to several decades. Investment-grade bonds are considered the safest and give low returns, while junk bonds provide better returns, have a lower credit rating, and have a greater chance of default.
Equity vs Fixed Income Infographics
Key Differences
#1 - Ownership
Equity holders are the company's owners. They have voting rights on important matters and have a say in their functioning. Also, they have the first right on profit and are paid dividends. However, if the management decides on using the profit for other activities like reinvesting in the business or any mergers or expansions, one cannot question them. Hence dividends can be paid out but at the discretion of the management. On the other hand, Bondholders do not get voting shares or rights in the profit. They are creditors to the firm and are only guaranteed fixed returns and the principal amount at maturity.
#2 - Risk and Returns
It has been proved that equity returns have surpassed fixed income returns. However, to gain those returns, risks undertaken by the investors have also been huge. Who can forget the great economic depression of 2007-2008 or the dot-com bubble of early 2000? There have been times when stock markets have crashed by more than 25% – 30% to 40% at some rare times.
Similarly, there have been times when the stock markets would have given more than 35% returns in a single year. These volatile returns make investments in equity highly risky and volatile. There are mainly two types of risks here: systematic and unsystematic risks. Systematic risks arise because of market volatilities during various economic periods. Unsystematic risks refer to the characteristics of individual firms and can be avoided through diversification.
On the other hand, fixed income provides certainty to your investments. Once you have invested in a bond, you are sure of the returns and the principal you will get. Interest rates may vary during periods of economic expansion or recession, but the guaranteed coupon payment you have received will not change. These stable returns of fixed income make them very attractive to risk-averse investors.
However, these fixed but low returns can mean that your investments might not be able to keep pace with inflation. In simple terms means that you are losing money year on year. In addition, the typical risk with fixed income securities is default risk – the risk that the issuer might default and be unable to pay back the periodic cash flows and the principal at maturity. However, this risk is very low for sovereign securities like government treasury securities.
#3 - Bankruptcy
In case of a credit event like bankruptcy, if the firm or the issuer defaults, both investments are lost. In such a case, the firm's assets are liquidated to generate cash. The amount thus received is first claimed by bondholders, and once they have been compensated, the remaining amount is given to equity holders.
Equity vs Fixed Income Comparative Table
| Criteria | Equity | Fixed Income |
|---|---|---|
| 1. Status | Equity owners have shared companies, allowing them to claim profits. | Bond owners are creditors who can only claim the loaned amount and interest earned. |
| 2. Issuers | Corporates mainly issue equity. | Firms issue government, financial, or corporate issue bonds or corporate deposits. |
| 3. Risk | It is highly risky as it depends on its performance and the market conditions. | Low risk is promised a fixed interest irrespective of the firm's performance. |
| 4. Claim to assets | In case of bankruptcy, they have the last claim to assets. | In the case of default, debt holders have prioritized over stockholders. |
| 5. Returns | High returns compensate for high risks in the form of cost appreciation. | Low but guaranteed interest returns. |
| 6. Dividends | Dividends are cash flow of equity but paid at the discretion of management. | No dividends are paid. |
| 7. Involvement | Since stock owners are the firm’s owners, they have voting rights. | Bondholders have no say in the company matters and voting. |
Conclusion
Both are important concerning portfolio allocation. Also, the investment categories’ equity and fixed income returns are non-correlated. As a result, fixed-income investments add predictability to your portfolio, while equity investments help beat inflation and increase your financial worth by taking advantage of higher payoffs.
A prudent investor focuses on maintaining a balanced portfolio by investing in a combination of equity and fixed income products depending on his level of risk tolerance.
