What are Equity Investments, and How Do They Work?

Investment options include fixed investments and equity investments. Fixed investments like bonds, savings accounts, CDs, and IRAs provide stability. Equity investments can increase your net worth with less risk than you think. Learn more below.

last updated Wednesday, April 24, 2024
#equity investment #what is equity investment

John Burson

CONTENTS

The investment industry offers many options for building, maintaining, and increasing wealth. However, stock investing may seem too complex without professional financial advisors. For this reason, you may prefer to invest in fixed investments, such as government bonds, high-yield savings accounts, CDs, and IRAs.

If you choose the fixed investment option, you could miss opportunities to substantially increase your net worth without as much risk as you think. Contrary to the general perception, making your money grow with equity investments is simple once you understand the concept and the rules.

This guide will thoroughly explain:

What equity investments are
How they work
Equity investment benefits
Equity investment risks
Equity strategies
How to invest in equity investments

What is Equity Investment?

What Is Equity?

In the case of company liquidation, equity is the money left after a company pays off all debts in the case of liquidation.
In the case of company acquisition, equity is the money calculated as acquisition value minus all liabilities.

What Is Equity Investment?

Fig 1. Equity investment infographic

The equities investment occurs when an investor buys stocks directly from a company or other individual investors.

The desired outcomes of the stock purchase are:

to collect company dividends,
and profit from reselling the stocks.

Companies use money from equity investors to raise capital (funds). The money you use to purchase shares in the company is your equity. It also represents your ownership interest in the business. The number of shares you own will determine your dividend amount if a company offers a dividend. So, you are sharing in the company's net profits due to your partial ownership.

If the value of your stocks rises, your shareholder equity will increase accordingly in the form of capital gains, the difference between the amount of your initial investment and its total increase. Capital losses are the opposite.

How Equity Investment Works?

Equities investment provides two main functions: it is a non-debt way for companies to raise money for growth and allow investors to share in the company's profits and growth.

When you purchase a stock publicly or privately, you own a proportionate share of the company's assets, which equals its total assets minus total liabilities.

Example of an Equity Investment: Champion Homes

Grand Champion Homes

Grand Champion Homes is a company that manufactures, distributes, and markets emergency home structures. Along with fulfilling government contracts worldwide, the company struggles to meet the ballooning demand from consumers seeking to buy Grand Champion Homes as secondary and primary dwellings.

This company has been in business for five years and has done four rounds of venture capital funding [1]. However, it needs significant capital to take advantage of a 10x increase in demand for its structures. So, instead of going public on the major stock exchanges, Grand Champion made shares available to investors through a private equity (PE) firm because its founders believe they need the added guidance that a private equity firm provides.

The private equity firm typically buys a controlling interest in the company. Then, it sells its ownership shares to limited partners (LP), such as institutional investors, family offices, funds of funds, foundations, etc.[2]. However, retail investors can buy publicly traded stock through some private equity investment platforms. Regardless of how or where investors buy Grand Champion stock, they get proportional ownership of the company's net assets. This shareholder equity entitles them to a proportionate share of earnings and any increase in value. Also, the shareholder's potential losses end with their total money invested, not liabilities assumed by Grand Champion.

With the new pool of capital, Grand Champion can execute its expansion plans and settle old debt. The private equity firm will cash out its interest at a specified time (3 to 4 years). Private equity investors typically stay with the deal until then. But if the company had chosen to offer its shares through the stock market, public investors would be free to buy or sell anytime.

Why should I consider equities?

If you are like most people, you may never gain the resources or the good fortune required to own a large company. And even if you did, you may not want to spend most of your waking hours establishing and advancing the business. Equity investments allow you to take a passive contributing role in the growth of a major company(s) with the possibility of sharing in its earnings and increases in value.

Benefits of Equity Investments

Here are the primary benefits of equity investments.

Potentially Higher Rate of Return on Investment
Equity investments, particularly ones in the U.S. stock market, have the highest return rate on investments [3]. And they have historically outperformed other investment types over time. The primary reason for this advantage is that companies offering equity to investors usually have viable growth potential. For this reason, the share prices of these companies are more likely to increase in time as the business prospers.
Portfolio Diversification
Unlike commodities and other investments with potentially high yields, equity investments are usually less volatile. This characteristic can help you level off your portfolio's peaks and valleys, especially if you are looking for risk reduction. If you prefer the best option for diversification, an equity fund should serve that function well.
Tax Breaks
When you invest in equity, you may be eligible for select tax breaks. The main reason is that the IRS levies less tax on profits from a sale of equity than other sources of income. So, equity investments deserve strong consideration if you are looking for less tax liability.

Risks of Equity Investments

Almost all investors seeking decent returns face varying amounts of risks. Equity investors are no exception. These are the main risks of equity investing worth considering.

Fig 2. Equity investment risks

Liquidity Risk
Some equity investments are less liquid than debt investments, meaning you may have difficulty selling them if you need a quick cash infusion.
Volatility
Although equity investments are less volatile than other investments with high earning potential, they are inherently volatile. For this reason, the price of your stocks can go up or down very steeply in a brief period. This volatility could stem from a shift in the economy, favorable or unfavorable company news, and several other internal or external causes.
Riskier than Debt Investing
Investing in equity is riskier than debt investing. Since a company can go bankrupt, you can lose all your equity. It can also encounter financial difficulties that cause its stock price to drop.

Popular investment strategies

Since you can choose various securities, equity investments can fit into many strategies. Here are some of the most popular equity investment strategies.

Value Investing
Value investors are the bargain hunters of the stock market. Made famous by prominent investors like Warren Buffett, value investing involves purchasing a stock perceived to be undervalued with a potential for substantial long-term gains. This strategy stems from the theory that irrationality is present in the market.

value investing

Fig 3. Value investment infographic

As a result, value investors believe this irrationality can allow them to buy a stock at a discount and eventually profit from the sale. Value investing usually requires investors to have a hound dog mentality toward scanning the market and news services to indicate an undervalued stock is available.

For example, the stock price of a successful aircraft engine builder drastically fell because of a costly executive decision. Based on an erroneous forecast, they focused on building engines for large commercial planes. However, their major airline customers have moved toward smaller planes instead. Many investors will divest from a company at any sign of a threat to future earnings.

On the other hand, a value investor may conclude from research and experience that airline companies will eventually renew their interest in using bigger planes. Value investors may consider the sudden price drop a sign of irrationality and capitalize on it by buying the company’s stock.

Although value investing can produce significant gains over the long term, value companies are often challenging to find, and the investment carries considerable risk. It also requires an investor with exceptional drive, patience, and insight. Value investing has yielded superior returns for investors who have mastered it. However, there are extended periods of underperformance that can reduce your portfolio diversification.

Growth Investing
Both public and private equity investors use growth investing. In both cases, growth investors target companies out of the venture capital or initial public offering stage with some substantial equity build-up. The company must also offer robust upside potential for future earnings. Ideally, growth investors seek to invest in the next Apple or Amazon.

Although it has long-shot characteristics, growth investing is not speculative investing. Investors typically conduct probing research and analysis of the company's present state and its growth potential, including:
- Researching the company's financial history
- Interviewing clients
- Trying the company's products or services
- Conducting interviews with the business's founder and team
  
  Many private equity firms keep a database of promising companies and track their financial activity for 10 to 15 years. This process allows them to single out target investment companies. Stock market investors can also do extensive technical and fundamental research on listed companies with growth potential.
  
  Since growth investments are riskier and require specific economic conditions to excel, investors must have a high-risk tolerance for periodic drops in value. Also, growth investments usually don't provide dividends— and growth investing underperforms compared to value investing. So, ideal growth investors disregard cash flow or dividends to pursue investment opportunities with shorter investing horizons and higher potential than value companies.
Active Investing
Active investors attempt to profit from market fluctuations by frequently and opportunistically trading stocks. They typically use technical analysis to help them anticipate a rising point in the market prices [4]. This type of analysis involves reviewing historical market data, such as price trends and trading volume, to identify patterns indicating the subsequent rise in market prices [5].

Active trading involves using various pricing-based strategies that depend on market timing. Some of the common ones are:
- Swing or spread trading
  Uses favorable risk/reward metrics to leverage short-to-medium-term price movements.
- Momentum investing
  Attempts to capitalize on market sentiment by finding and following favorable trends.
- Event-driven trading
  Seeks to profit from price movements (up or down) caused by corporate events or changes, such as mergers, bankruptcy, and stock splits.
  
  Even with cutting-edge technology, timing the market is challenging. Active traders must always be at the helm, ready to buy, and continually do technical analysis. Since active trading is highly speculative, it ranks among the riskiest strategies. This investment strategy requires highly skilled traders to judge entry and exit points consistently.
Fund Investing
Index investing allows you to benefit from active or passive investing. Either way, you can use index funds, mutual funds, and exchange-traded funds (ETFs) to access a bundle of stocks, bonds, and other securities. As a result, funds can add diversification to your portfolio.

Mutual funds use an active investing strategy executed by a fund manager. Tasked with outperforming passive funds, a fund manager uses proprietary research, analysis, and predictive formulas to fill the fund with handpicked investments.

On the other hand, passive index funds and ETFs track an underlying index to offer investors a similar portfolio performance to that index. Popular market indexes that funds follow are the Nasdaq 100, S&P 500, and Dow Jones Industrial Average.

Although market indexes consistently outperform most mutual funds, the minimum investment for mutual funds is higher[6]. In addition, there are thousands of mutual funds, and picking the high performers can be as challenging as picking stocks. These factors make it difficult for mutual funds to compete with index funds as the better long-term investments.
Venture Capital
Private equity firms use the venture capital (VC) strategy as a structure for investing in businesses needing capital in the early startup stage. As part of the strategy, venture capitalists provide a company with a designated amount of seed funding in exchange for a minority share of the company, typically under 50%. This arrangement is agreeable to the company’s founders because they usually want to retain controlling ownership.

By its nature, VC investing is risky because most startups have little resources and no profit-making history, resulting in no return guarantee for VC investors. However, they can make billions of dollars if the company becomes the next big success story, like Apple, Microsoft, or Twitter.

Venture capitalists use a customized blend of speculation and strategic prowess. It takes uniquely skilled investors to survive using this private equity strategy. However, statistics show that venture capitalists with a successful track record with startups have a greater chance of continuing to make profitable VC investments.

How Can I Invest in Equities?

For many decades, equity investments have yielded the highest average rate of return of all other investments. However, their profit-earning potential comes with possible severe risks, especially for novice and casual investors.
This potential for financial harm is why your first step to investing in equities is educating yourself about stock investing, the stock market, and private equity investing. You should learn all the precautions you can take to reduce your risks. Fortunately, there is much information on equity investing online, including on Paperfree.com.

Here is the high-level plan you may follow:

Once you have built up your investing IQ, set clear goals and a budget.
Set aside money in your budget that you can afford to lose. And ensure that you put aside money for emergencies and debt repayment.
Next, choose a brokerage compatible with your requirements, such as fees, research tools, and user-friendly interface. There are many online brokerages offering access to the stock market.
Invest in private equity. Although the practice is still rare, some private equity firms like Blackstone and Paperfree offer platforms for alternative equity investments for retail (non-accredited) investors [7].
After selecting the stocks for your equity investment, you can place buy or sell orders via your brokerage account, using any strategy you choose.
Unless you invest in mutual funds or ETFs, it is essential to monitor your portfolio because stock prices are potentially volatile regularly.

Why Paperfree.com

Paperfree.com is a real estate investment company providing investors access to systematically vetted, diversified investments. Its investment platform features Real Estate Funds and managed collaborations, allowing accredited and non-accredited investors to find the best investment product for their needs easily.
To this end, Paperfree.com acquires underperforming and undervalued businesses backed by real estate assets throughout the U.S. (value add strategy). We boost business performance by using the following:

Management optimization
Operating efficiencies
Real estate asset repositioning
Strategic property improvements

Focusing on capital preservation, Paperfree.com looks to acquire properties in the nation's top 50 MSAs at a discount from intrinsic value. We hold these acquisitions for optimal returns and disperse the earnings and profits to our investors and partners. If long-term, value-oriented investing in real estate-backed assets appeals to you, Paperfree.com's disciplined acquisition strategy may be a profitable equity investing vehicle.

Citations:
[1] https://gouchevlaw.com/stages-venture-capital-financing/
[2] https://www.investopedia.com/terms/i/institutionalinvestor.asp
[3] https://www.investopedia.com/ask/answers/032415/which-investments-have-highest-historical-returns.asp
[4] https://www.investopedia.com/terms/t/technicalanalysis.asp#:~
[5] https://www.nasdaq.com/market-activity/quotes/historical
[6] https://www.sec.gov/spotlight/sbcfac/expanding-retail-access-to-private-markets-finley.pdf
[7] https://www.cnbc.com/2022/03/21/why-index-funds-are-often-a-better-bet-than-active-funds.html