Equities are stocks – shares in a company. If you buy stocks, you’re buying equities. You may also get “equity” when you join a new company as an employee. That means you’re a partial owner, or can be, of shares in your company. Because equities don’t pay a fixed interest rate, they don’t offer guaranteed income. In other words, with equities comes risk.
Check out our retirement calculator.
Equities: The Basics
The term equity has a different definition depending on the context. Let’s talk about the definition of equity in the context of the stock market. In simplest terms, equities are shares in the ownership of a company. When a company issues bonds, it’s taking loans from buyers. When a company offers shares, on the other hand, it’s selling partial ownership in the company.
People invest in equities because of their potential for high returns. In your investing portfolio, your “equity exposure” is another way of describing your exposure to the risk that you will lose money when the value of the stocks you own declines. Conventional wisdom states that young people can afford more equity exposure, and therefore will likely want more stocks in their portfolio because of their potential for returns over time. As you approach retirement, equity exposure becomes more of a risk, which is why many people transition at least part of their investments from stocks to bonds as they get older.
Check out our 401(k) calculator.
If you own equities, the value of your holdings increases when the shares you own become worth more than what you paid for them. But that’s not the only way you can come out on top by owning equities. Companies also pay dividends out of their own profits and into the pockets of their shareholders. Dividends aren’t guaranteed, but they’re pretty great. As an investor, you can either reinvest your dividends or take them as income.
If you own equities, it’s important to understand the difference between capital gains and dividends. You may have heard of capital gains, either because you benefit from them (congrats!) or because you follow the ongoing political debates on how they should be taxed. A capital gain is the difference between the price at which you bought shares and the price for which you sell them. There are long-term and short-term capital gains, each with its own tax rate.
Dividends, as we’ve explained, are periodic payments made from the company to its shareholders. They’re taxed like long-term capital gains, as long as they’re “qualified dividends.” If you own equities, your broker or fund company should provide you with IRS Form 1099-DIV that breaks down your dividends and capital gains for the year.
Related Article: Getting Started with Retirement Planning
Owners of preferred stock get more access to earnings and assets than owners of “common stock” can claim. Preferred shareholders are more likely to get regular dividend payments (usually at a fixed rate) and they get paid before the owners of common shares. Not bad, right? The catch is that, because dividend rates for preferred shareholders are generally fixed, the owners of preferred stock won’t see their dividends jump as the company becomes more profitable.
In the event that the company goes bankrupt or is liquidated, preferred shareholders have dibs on assets and earnings before common shareholders. In the hierarchy of who gets to take a company’s assets if it folds, bondholders are at the top, since they’ve loaned money to the company. Preferred shareholders are next, followed by common shareholders.
Getting Equity Through Your Job
Say you get a job offer, complete with salary, health insurance, a 401(k) and equity. What exactly does “equity” mean in that case? It means that you either have an ownership share in your new company now, or you will have when your equity “vests” – in other words, when it becomes official by virtue of the fact that you’re still with the company. In some cases, your equity is given to you outright, while in others it consists of the option to buy stock at a preferential price.
Equity alone does not a great job offer make, however. Unless your company goes public or is sold (these are known as “exit events”), your equity won’t pad your bank account. Plus, since your salary is already tied to the fate of the company, the more company stock you own the more financial eggs you’re putting in that one basket.
When you invest in equities, it’s important to understand the risk you’re taking on. It’s also a good idea to fight against your natural biases. Most people’s instinct is to buy stocks when they’ve already risen in value (this is called “buying high”). Then, in a stock market downturn like a recession, people panic and sell off their shares (“selling low”). But to be optimally successful in the equities market, you’ll need to do the opposite of what feels right. You’ll need to buy low and sell high.
If you don’t think you can overcome the natural tendency to buy high and sell low, you may be better off staying out of those decisions altogether. Investing in an index fund that tracks the general market will take the power to buy and sell individual shares out of your hands.
Photo credit: flickr, ©iStock.com/xavierarnau, ©iStock.com/sturti