My finances, my projects, my life
December 13, 2019

An explanation on equities

  Compiled by myLIFE team myINVEST May 29, 2018 388

Equities are one of three primary investment vehicles, next to bonds and cash equivalents. Following previous publications on myLIFE in which we discussed bonds and commodities, we now drill down into equities, exploring their key features, advantages and the risks associated with their inclusion in a portfolio.

Equities – also known as stocks or shares – represent ownership rights in companies. By purchasing a regular equity in a company, the investor:

  • Is generally entitled to vote in shareholder meetings, potentially steering the future direction of the company. The more shares you own, the more weight you carry in terms of voting power. Shareholders appoint the company’s board of directors.
  • Is entitled to a slice of the company’s profits (in the form of a dividend), based upon the amount and kind of shares they hold. It is true that some companies do not pay a dividend, however, in this case, the dividend is reinvested in the business to fund growth, and the retained earnings are still reflected in the stock’s overall value.
  • Can benefit from capital appreciation – that is if the stock is worth more than they paid for it at the point they decide to sell it.

Stocks can be traded on exchanges (also known as ‘stock markets’). Some of the most well-known stock markets are the New York Stock Exchange (NYSE), the NASDAQ, Euronext and the London Stock Exchange (LSE). When a company first offers its shares on the stock market, this is known as an Initial Public Offering (IPO). Thereafter stocks can also be bought and sold on secondary markets. However, not all shares are the same. There are two main types of equities: Common Stock and Preferred Stock.

… stocks are inherently a riskier investments that bonds

  • Common Stock. Holders of common stock own residual rights to the assets of the company. They have the right to receive any dividends declared by the company and, in the event of liquidation, any assets remaining after all other claims are paid. However, because creditors (e.g. bond holders) are given priority over other stakeholders, normally there is very little left of the pie when it comes to the point when shareholders receive their slice in the event of bankruptcy. This implies that stocks are inherently a riskier investments that bonds.
  • Preferred Stock. Preferred stocks offer a greater claim on the cash flows and assets of a company relative to regular shares. They come first-in-line (relative to common stock) in the event of a liquidation.

What governs the price of shares

Share prices can be very volatile. They are influenced by supply and demand factors, but as well by investor emotions. Share prices move based on company and industry specific news, such as earnings reports, and broader macroeconomic events.

Investors can be fickle. As an example, in 2018, after a reality TV Star – Kylie Jenner – tweeted that she no longer used Snap Chat, investors rushed to sell, wiping $1.3 billion from the company’s market value without any change in fundamentals.

On aggregate, the market tends to go through phases of rising or falling prices (though individual names can still swing). When stock prices, in general, are expected to rise, this is called a bull market. This is why, if you visit Wall Street in New York, there is a large bronze sculpture of a charging bull. When prices are expected to fall, this is referred to as a bear market.

Some companies try to control their share price. An example of such a company is the Swiss Chocolate-maker Lindt & Sprüngli. Since 2015, the stock price has stayed above 50,000CHF – that is over 43,000EUR for one single share. This reduces the number of daily transactions, making it difficult, for instance, for retail investors to acquire shares and for hedge funds to speculate on the share price and encourages buy-and-hold long-term investors. Companies can also buy-back their own shares or do stock splits to increase the number of shares in circulation.

Investors should purchase stocks like they purchase groceries, not like they purchase perfume

Diversification is a key tool in reducing the risk of equity investments – investors should hold an array of stocks in uncorrelated sectors / industries. The famous investor Ben Graham once said: “Investors should purchase stocks like they purchase groceries, not like they purchase perfume”.

Different stocks have differing levels of risk. At one end of the spectrum, there are blue-chip stocks which represent the shares of well-established companies that are typically leaders in their fields. At the other end of the scale, there are penny stocks, which are often not even available on major exchanges because they do not meet minimum listing requirements. These type of stocks are often highly volatile, which can offer a higher potential for quick gains, but also a much steeper downside.

Investors who can palate more risk normally have a portfolio which is more equity-heavy. A mix of both equities and bonds is recommended for more risk-averse investors (proportions are variable depending on the level of risk aversion and individual circumstances).

In any case, but especially if you don’t know that much about investing, it’s better to place your trust in professionals. As Warren Buffett said: “Following rules is investing. Following emotions is betting.”