Fixed Income vs. Equity Explained
Common investing wisdom says that equity brings you high returns while fixed income keeps your money safe. Here's how they work together.
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If you could only pick one, would you prefer your car to have a gas or a brake pedal?
Obviously, you need both: Without gas, you won’t get anywhere, and without brakes, you’ll crash as soon as you hit a sharp turn. The same applies to fixed income and equity in your portfolio—it’s less about selecting one and more about balancing both (the right way).
One gives you good profits and the other keeps you safe, so understanding and applying how they can complement each other will improve the outcomes of your investment strategies. After all, you want your money to grow and not disappear the next time that a FED chairman coughs at a news conference and accidentally crashes the market. 📉
Indeed, the markets can be very chaotic and sensitive to all kinds of events—as we’ve clearly seen in the COVID19 era. Just when you thought inflation was the biggest threat, a sick bat (or pangolin) from China ends up dragging the performance of the S&P 500 down by 34%.
There is a wide range of factors that can affect the performance of an investment, so when you’re not careful, that’s when you’re most vulnerable.
The good news is that the more familiar you are with all the ups, downs, and resources of an investor’s portfolio, the better. This guide will cover how fixed income and equity work, what their benefits and drawbacks are, and how they can complement each other. After all, who doesn’t want their portfolio to be healthy and ✨crisp✨?
- What is Equity?
- What is Fixed Income?
- Fixed-Income vs. Equity Markets
- How to Easily “Balance” Your Portfolio
- Conclusion
- Get Started with a Stock Broker
What is Equity? 📙
Equity investment is when you make an income by trading shares and other securities on stock exchanges. Shares represent a part of a company, otherwise known as the company’s stock. Nevertheless, equity works by allocating money with the expectation of generating profit in the future.
Imagine that when your grandfather isn’t busy sleeping deeper than a bear in hibernation, he’s been fixing up a 67’ Mustang worth $75,000. Likewise, he only owes $45,000 on that vehicle. The car itself represents $30,000 equity.
Just like Gramp’s profiting side-hobby, equity is the amount of money that would be returned to the company’s shareholders if all the investments were liquidated and all the company’s debt was paid off. Additionally, it represents the value of an investor’s stake in a company which is represented by the proportion of its shares.
For instance, you can invest in Apple by buying shares of the company in the stock market. Those shares, or ownerships of Apple, are then traded on a stock exchange. You make a profit when you trade your share for more than what you bought it for.
The Purpose of Equities in a Portfolio 👨🏫
Stocks have a lot of potential to grow. But, like carrying an excessive amount of groceries from your car in one trip to get more done in less time, you’re gaining more benefit for less when you invest with equity. It’s all about how you go about it.
Wise investors will only invest in a firm if they believe their investments can grow with the firm. By doing this, stocks can provide several roles or benefits to a portfolio. This can include dividend income, capital appreciation, diversification with other asset classes, and a potential barrier against inflation.
While stocks can be very profitable, they can also be hurt for a wide range of reasons. If a company goes bankrupt or a stock’s demand sinks, it will lose much (if not all) of its value. Even a poor PR can wipe a stock off the map.
Equity offers investors a diversified investment option for a minimum initial investment amount via premium stock trading apps. Some investments are risky but profitable while some are low risk but don’t give you much. The more groceries at once, the faster, the fewer groceries, the easier—but if you drop them, it’s a much bigger waste.
What is Fixed Income? 📘
Brake checking a Karen who’s been on your tail for the last 5 minutes sure sounds fun, but without a dashcam… good luck in court. The same goes for going all-in on a risky stock—it’s usually not the wisest way to make profits. Take Warren Buffett’s first rule of investing: Don’t lose money—that’s where fixed-income securities come in.
Fixed income works by investment sources paying a set interest rate return in exchange for investors lending their money. These investments consist of government bonds, CDs, and money market funds, along with government or corporate bonds (units of debt).
Fixed income isn’t Iron Man fighting and risking his life to save the world—that’s equity. Fixed income is Tony Stark enhancing his suites in his lab to protect his Iron Man-self against a potential evil.
It is the class of assets and securities that pay an outset level of cash flows to investors. At the maturity date, investors are repaid the original amount they had invested. The repaid amount is known as the principle, whereas the profited amount is known as par or face value.
What is it protecting against? Inflation is predicted to be a top economic challenge in 2020s, not to mention potential market crashes. However, fixed-income securities won’t fully protect you against inflation—in low interest rate periods, the yields that these securities provide can be too low to match the rate of inflation.
Despite this, fixed income is the Avenger you want on your team when you want to safeguard your money from potential market crashes and recessive periods. Although any bond of fixed income can decline in value, you can count on still receiving full repayment of principal plus interest if you hold high-quality bonds to maturity.
What Affects Fixed-Income Security Prices? 🤔
Like your Uncle Jim’s over-exaggerated hunting stories, how much you earn with fixed-income securities is influenced by a few different things. These things include external factors, one of which is changes in federal interest rates.
Fixed-income bond prices are heavily impacted by interest rates—as the interest rates rise, the price of bonds falls. This is because investors can get bonds with a superior interest rate which decreases the value of a bond that has already been issued when inflation was lower. But a high-interest rate also means higher bond yields, which means more money if you hold the bond until its maturity. 💸
Default or credit risk is also a contributing factor—especially with bonds issued by unstable companies. This is the risk that the issuer will go out of business and be unable to pay its interest rate and principal obligations. Issuers of high-yield bonds have more credit risk since there is likely to be a greater risk of default.
To compensate investors for this higher risk, such bonds often pay higher interest rates. Unlike publicly-traded stocks where investors can easily exit a position, there’s no central place or exchange for bond trading. So given that most bonds are traded on over-the-counter (OTC), it means they carry what is known as liquidity risk—the difficulty exiting a position.
Liquidity risk is the risk that the price of a security will plunge when the market becomes illiquid (difficult to convert into cash). For instance, you may own real estate but it owes to poor market conditions and can only be sold quickly at a fire sale price—a price well below the market value. 📊
Also, due to the less active market for bonds, it can be difficult to get the most up-to-date price. Fixed income bonds vary so much in their maturity periods, yields, and the credit rating of the issuer that centralized trading is difficult. Equity may not be flawless—but as Uncle Jim said, it’s worth a shot.
Comparing Fixed-Income and Equity Markets
Great! You’ve got fixed income and equity under your belt. Now, let’s take a look at how they distinguish from each other.
Risk ⚠
When it comes to risks, nothing is ever completely free of them. This excludes pushing the lock button on your car keys at least three times before going into Walmart—then you’re safe.
Both stocks and fixed income are at least at some risk of unpredictable credit, inflation, interest rate, exchange rate, call/prepayment, volatility, event, reinvestment, political, and sector risks.
But overall, stocks are riskier than fixed income because they depend on the performance of the underlying companies and overall market conditions. This means there’s a higher chance you’ll lose more money if worst comes to worst.
Fixed-income securities are safer because they promise a steady income regardless of the firm’s performance— even the time and amount to be received. Despite their securities experiencing slight price changes compared to stocks, fixed income is overall less risky because it’s more predictable than stocks are.
Ownership Status 👔
Equity owners have shared owners of the company which allows them to claim a profit. In other words, you’re considered an owner of the company—that doesn’t sound too bad, huh?
Fixed incomers are creditors that can only claim the loaned amount and interest earned on it. So, they don’t own any part of a firm, just the money they put into and gained from it.
Stocks are mainly issued by companies and financial institutions like central banks, credit unions, savings, and loan associations. On the other hand, bonds are mainly issued by large companies and governments.
Potential Returns 💰
When the fake friend who dodged your wedding asks you for an annoying favor, what is the first thing that pops up in your head? “What’s in it for me?”
Equity’s high returns compensate for the high risks in the form of cost appreciation. It can help to beat inflation while increasing your financial worth by taking advantage of higher payoffs. The average annual stock market profit has stabilized at 10% in the last century.
When the corporation you partially own earns a profit or surplus, it pays a proportion of the profit as a dividend to you, its shareholder. For example, if a company issues a stock dividend of 7%, it will be required to issue 0.07 shares-worth of money for every share owned by existing shareholders. For example, if you own 100 shares that means you would receive a cash equivalent of seven additional shares.
Fixed income has less dramatic results but has guaranteed interest returns. In fact, it has a promised fixed amount of cash flows along with fixed dates. 📅
You will receive the receipt of the promised income and principal payments on the scheduled dates, reinvestment of income payments, and potential capital gains on the sale of the bond prior to maturity. Overall, fixed income adds predictability to your portfolio.
Basically, stocks give you dividends with more return and fixed income gives you interest with less return. No, not that kind of interest—unlike the last election, they are both interesting.
All-in-all, equity earns you more money whereas fixed income makes sure you don’t lose any. Equities are the fighters, bonds are the protectors.💪
Bankruptcy 🚧
Equity has the last claims to assets in case of bankruptcy. So if a company goes bankrupt, you lose all your money because the value of your share goes to 0. Yet, if you hold that company’s fixed income bonds, you get paid before the equity shareholders.
Research shows that deep down inside, the majority of parents do in fact have a favorite child. In the case of bankruptcy, bonds are that favorite child.
This means that debt holders (fixed income) are paid first and prioritized over stockholders (equity) when in case of bankruptcy. Moreover, many bonds are insured by the government—even if the company cannot pay, you still get your money back as a debt holder.
In bankruptcy, the assets of the firm are liquidated to generate some cash. The amount thus received is first claimed by bondholders and once they have been compensated. The remaining amount is given to equity holders.
For example, if you invested in cheap restaurant service industry stock after the COVID era started you would have seen bankruptcies every time a new variant was discovered. In this case, hopeful stock investors lose everything, while bond holders retain their wealth.
How to Easily “Balance” Your Portfolio 👷♂️
Investing takes a lot of time and stock research. A prudent investor focuses on maintaining a balanced portfolio by investing in a combination of equity and fixed income products.
After all, Tony Stark wasn’t out saving the world the whole time, nor was he always hedged in his lab. He balanced out both the risk-taking and the protection-making.
Most people buy stocks to help their portfolio grow, and fixed securities like bonds to keep their portfolio safe. Given this, they split their portfolio down the middle—half for equities, half for fixed income.
However, analysts have long encouraged a 60/40 portfolio in which the equity stocks take up 60 percent of your portfolio, and bonds take up 40. Regardless of how they do it, investors have to manage their risk levels by changing the ratio of stocks to bonds.
Balancing and risk-adjusting your portfolio is most commonly managed when you buy already diversified exchange-traded funds (ETFs). It behaves like stock because it is a group of securities traded on an exchange.
ETFs share prices and fluctuate all day as the ETF is bought and sold. They can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. They can even be structured to track specific investment strategies.
For example, an investment-grade bond ETF would be an easy way to earn more income than in a savings account with limited risk. An example is the SPDR S&P 500 which tracks the S&P 500 Index—the “best” stocks out there.
Since Covid hit, the S&P 500 index has been on its absolute maximum. Fortunately, ETFs offer stocks large reductions in idiosyncratic risk and easier access to foreign markets. 📈
ETFs contain all types of investments like commodities, bonds, or stocks. Investors achieve instant diversification and can often determine the quality of securities by merely looking at the label. Who knew reading labels doesn’t always have to end in shame?
Like items on Wish, ETFs are diverse and fairly cheap. They provide fewer broker commissions and expense ratios at low costs (management fees you have to pay) than if you were to individually buy the stocks. They are more accessible to all investors given they often have reasonable prices below $100 per share.
If you want to spread out your investments but don’t have time to do all the research yourself, ETFscan be very handy— especially when bought through a premium broker. That’s right— the more lawful Jordan Belfort’s of the world can easily get your hands on an ETF. The top ETF brokers are safe and have zero trading commissions while offering a wide selection of professionally managed ETFs.
Conclusion 🏁
Great job! You’ve made it to the end. Now you are more aware of equity, fixed income, and how you can go about creating an equilibrium between the two.
Equity investments get you more income for higher risk, whereas fixed income gets you less income for lower risk. Obtaining an ETF through a premium broker is the easiest, most common, and affordable way to balance out your portfolio. Now that you’ve got the info you need, go get what you want! 💨
Fixed Income vs Equity: FAQs
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Can Equity or Fixed-Income Receive Dividends?
Only equity can receive dividends. Dividends are the cash flow of stocks and can only payout to equity investors. However, companies are not obligated to do so, and you should check if a company has a dividend program before investing in it.
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Is Real Estate Equity or Fixed-Income?
In general, real estate does fall into the equity category. Real estate, mutual funds, and stocks are all examples of equity because they value shares issued by a company.
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Can Fixed Income Funds Lose Money?
Like anything, yes—it is possible for fixed income funds to lose money. Remember that because bond funds are frequently buying and selling securities and seldomly holding bonds to maturity, it is possible to lose up to all of your original investment.
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Who Has More Involvement in a Company—Fixed Income or Equity Investors?
Equity investors have more involvement in a company. They can have voting rights since stock owners are considered the owners of the firms, whereas fixed-income investors have no say in company matters.
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Why is Equity Called Equity?
Equity means ownership, and ownership defines equity in an investor’s portfolio. The word derives from French which means equal/ just/ even. This is because it gives the holder of equity a "right" in future profits.
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Is There a Difference Between Stocks and Equities?
Yes, there is a difference between stocks and equities. Stocks are those equity shares that are traded on stock exchanges. Equities are not traded on stock exchanges. Stocks involve general public participation. Equities do not involve general public participation.
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