So you have finally decided to start your investment journey (and if you still haven't, read here why you MUST start investing at the earliest) and you look up the internet for the best places to invest. But when the results show up, you are more confused than before. There is, of course, the stock market with thousands of companies and their shares as well as hundreds of mutual funds that invest in the stock market that promise you mouth-watering returns, but there are also hundreds of debt funds, bonds, debentures, fixed deposits, and other such ‘debt’ instruments on the market that entice you with guaranteed returns and scare you away from the stock market by calling it “risky” where you can lose all your money. But to choose what is right for you, it is important to understand the basic difference between equity and debt.
Debt:
Say, you wanted to buy a new phone but you don’t have the money. So, you ask your friend to loan you the amount and promise to repay it.
Your friend is smart though- she asks what is in it for her. You tell her that you will repay her money. "That you will, but what else?" So, you begrudgingly agree to pay a small sum as interest in addition to the principal amount. Essentially, you have taken a ‘debt’ or a ‘loan’ from your friend.
The same thing happens with companies, banks, governments and many other institutions. They all need money for their operations, expansions, expenses, etc. So they raise money from you, the investors through debt instruments like bonds, fixed deposits, recurring deposits, debentures, etc. You may ask why they don’t take loans from the banks. The reason is interest rates. They can raise money from investors at a lesser rate than the interest they have to pay to the bank. That way, they are able to get “cheaper” money.
The same is the case with governments- they also raise money by issuing bonds to the public. So if you buy a bond of $1000 from the government, you have essentially loaned the money to the government and the government MUST pay you that amount back along with the decided interest rate. Obviously, the longer you keep the money with the government, the more interest rate you get. So long term debt has more interest rates than short term debts. Even when you put money in a bank in either savings account or a fixed deposit, you are essentially loaning the bank your money which it then uses to give money to other people or companies.
When you invest in debt funds, what the fund is doing is using your money and that of all other investors to loan it to the corresponding institutions. So if you buy a corporate bond fund, it will use your money to buy corporate bonds i.e. bonds from companies; if you buy PSU bank fund, it uses your money to buy bonds of various PSU banks, and so on.
All debt needs to be repaid, with the pre-decided interest. So, if you put your money in a fixed deposit with a 6% interest rate, the bank must pay you back your money with 6% interest on it every year. Of course, you have to keep your money with the bank for the stipulated time period. Otherwise, the rules will not be followed. Similarly, in a debt mutual fund, the institution (companies, banks, etc) that the fund house loans your money to will have to pay back the money with the required interest rate, and you will get a return which will be an average of the many interest rates of all the bonds or debentures or other instruments the fund house buys.
But what if the bank collapses or the company gets bankrupt?
That is a very real possibility and in that case, the company must sell whatever it has in assets like properties, inventory, land, machines, etc. to pay back its debt. So this implies that the more the assets of a company are, the better it is in a position to “service” its debt. This is normally known as the credit rating of a company. The company with better credit rating has lower chances of defaulting (not being able to repay its debt). So, to ensure you get your desired returns, it is important to study what is the credit rating of the company or bank you are loaning your money to.
Equity:
Now imagine the first example again- You want to buy a new phone so you ask some money from your friend. But you know you are in no position to pay it back so you promise him you will let your friend use your phone instead for an hour a day. (No one would actually give their phone to someone else but go with me on this one).
Essentially, you have raised money by giving ‘equity’ of your phone. The same goes for a company. If it wishes to raise money without taking a loan, which may happen because either the company knows it will be unable to pay it back or it wants money for growth without taking on a loan, it may give up a part of its company in return and raise capital. If you have ever watched ‘Shark Tank’, you know exactly what I am talking about. ($200000 for 5% in our company, and so on)
Just like that, when you buy shares of a company, you are actually buying a part of the company. Publicly traded companies generally have a lot of shares, so 5 or 10 shares may be 0.000001% of a company but it is still a part of its ‘equity’.
So what is the difference between equity and debt?
Now the main difference between equity and debt is that equity doesn’t need to be repaid like debt because equity is not a loan. Equity is actually buying a stake in the company so if you bought 0.1% of a company when it was worth a million dollars, and ten years later, it is worth a hundred million, your 0.1% now rises 100x as well. Equity has the potential to grow your money much, much faster than a debt fund because your performance in equity is linked directly to the performance of the company, which can grow exponentially in the right circumstances and with the right people and products. That is why stock market is often touted as the place to make fortunes because many people have made fortunes by investing in the right stocks.
But in the off-chance this company loses a lot of money and is worth hundred times less, so is your share of the company and no one will pay back what you had invested. That is why stock market is often considered risky because many people have lost a lot of money too by investing in bad companies that went bust.
So how to you ensure you don’t lose your money in the stock market?
By understanding why you invested in a company. In an ideal world, the performance of your stock should directly depend on the performance of the company, and it does, more or less, in the long term. But in the short term, it is generally volatile and the prices rise and fall due to many reasons other than the company’s performance. So if you bought a stock for the company’s fundamentals, then it would be unwise to sell them based on short term volatility. However, if only bought it based off the stock chart, it would be stupid to not sell it if the stock chart indicates hard times ahead. So, it is important to understand the difference between fundamental investing v technical investing before you buy or sell a stock or mutual fund linked to the stock market.
Bottom line:
Equity and debt are the two ways any company or institution raises money. Debt is a loan that needs to be repaid along with a fixed interest. Equity is buying a stake in the company. You can make beyond your imagination or lose 100% of your money in equity. Stock market is where you buy equities of companies.
You, as an investor, can choose how you want to invest your money and divide it between equity and debt as per your risk appetite, investing objectives, and cash in hand. But remember, never be greedy or afraid.
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