Equities represent a partial ownership stake in a real business. Shares can technically have different conditions attached, which provide shareholders with different risks and rewards, but these are generally grouped into two categories:
Common shares
These are the dominant type of equity class and are what investors are generally referring to when they refer to ‘shares’ without any further clarification.
Preference shares
An uncommon form of share which grants its owner a higher priority over common shares when collecting dividends, or cash upon liquidation of the business. Some preference shares entitle their holder to a fixed interest payment, which makes them feel more like a bond than a common share.
I’ll describe the characteristics of common shares from this point onwards.
Reward – equities
A shareholder is entitled to their share of the profits, and total assets and liabilities of a company. In practice, each time a company declares distribution of profits to shareholders, each share will earn its holder a cash payment, which will be automated routed through to shareholders’ stockbroker account.
Dividends are paid at the discretion of management, and some companies don’t pay dividends at all, opting to reinvest the cash invested back into the business to generate higher growth in revenues and profit. The idea behind this is that a larger and more profitable company will be in a position to pay even larger dividends in the future, so this can be a worthwhile trade-off.
If a company’s prospects and dividends have grown over time, the price per share on the stock market will have also likely increased. A shareholder can choose at any time to sell their shares and realise a gain or loss on that investment depending on how the price has moved whilst in the investors portfolio.
Risk – equities
Of all the groups that provide finance to a company, shareholders carry the most risk.
Firstly, in the event of a bankruptcy, all other parties (including employees, suppliers, the tax authority and lenders) must be repaid in full before any cash is distributed back to shareholders. In practice, this leads to a total loss in the event of a collapse, as struggling businesses usually have insufficient reserves to cover all of the amounts that they owe.
Secondly, an investor who buys shares will experience ups and downs in the form of volatility in the share price. The prices of shares do not move in a steady trend. They gyrate quite significantly in an apparently random fashion over the short term.
This is the impact of shareholders and potential buyers in the market continually reassessing the value of the company in light of the most recent news and economic data.
This price risk is most apparent during economic crises when the perceived value of businesses falls substantially in a short period. Investors holding a basket of shares have been known to experience up to 60% losses in the space of 12 months during these periods.
That being said, the stock market has always historically recovered from such stock market crashes, and therefore this is an asset class which provides a more predictable reward over the very long term, such as 5 or more years.
Liquidity – equities
Shares in companies which are publicly traded on the world’s stock exchanges with the help of stockbrokers are a very liquid investment. Liquidity refers to the ability of an investor to convert their investment into cash in a short space of time.
Even during economic crises, investors can expect to find a buyer for the shares of major companies with relative ease during the trading hours of the stock exchange.
Once a trade is made, a share can be converted to cash within 2-3 days, which is the time it takes for the trade to be fully documented and for the cash to be exchanged between buyer and seller through an automated process known as a settlement.
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Emerging market equities
Investors tend to allocate most of their equity investments to large and mature businesses which are listed in the stock exchanges of highly developed economies, such as those of Europe, North America and Japan. Today, these exchanges account for over 75% of the world’s traded companies by value.
However, investors may decide to purposefully allocate a portion of their equity investments to businesses which are based in, and heavily exposed to high growth economies known as ‘emerging markets’.
The emerging markets include China, India and Brazil. As the economies of these countries have experienced a far higher rate of economic growth and technological development, it follows that their business will also experience a higher rate of growth. This has been proven correct over the last two decades.
However, investing in emerging markets carries an additional level of risk, including political and social instability, lighter regulations, and less effective rule of law. This translates to even higher volatility in share prices.
Having risen from $11 in 2003 to $54 by 2007, the MSCI Index (which measures the prices of a basket of large emerging market companies), had crashed back down to $19.82 one year later. It now trades at $43 at the date of writing this article in 2020.