While exploring investment options, you will frequently encounter the terms "Debt" and "Equity". So, do they matter to you as an investor? Yes, they do! You can infer significant information about your investment scheme if you focus on these two terms.
Debt is Owing and Equity is Owning
A very simple example of debt is lending money to your friend. We say that your friend owes you some money. Your friend has an obligation to pay you back the borrowed money.
Common example of equity is investing in your business or other's business by purchasing shares. When you buy shares, you buy ownership of the business. And then, you are entitled to get a share of profit which that business earns. But, you are also supposed to bear any losses which the business might incur.
Debt investment options/instruments
Fixed deposit, recurring deposit, provident fund, national savings scheme, debt oriented mutual fund..all these are debt instruments. In all of these schemes, you lend your money to someone with an expectation to earn a certain amount of interest. You don't buy any shares in these schemes. For example, when you put your money in bank in form of a fixed deposit, you don't care about profit and loss of that bank, you simply care about the interest that bank is offering to you. No matter how much profit or loss the bank makes, you will get your promised interest only. Same is the case with all borrowers. Their profit or loss doesn't matter to you, you are only concerned about the interest offered to you. For example, suppose you invest Rs. 100,000 in a fixed deposit for one year at an interest rate of 8% per annum. No matter if borrower makes a profit of 1000 Crores or a loss of Rs. 100 Crores, you will still get an interest of Rs. 8,000 on your investment. In rare cases, the borrower might go bankrupt and you may lose your money. Well, this is the risk involved with debt.
Equity investment options/instruments
Stocks, equity oriented mutual funds, real estate.. these are some common forms of equity investments. While investing in stocks, you take some ownership in the company. Your return on investment then depends on the performance of the company. You might make a fortune, but you might also lose everything. The risk with equity is quite high as compared to debt. You don't have any certain "interest " promised on your investment. But, you have chances of earning a high return which may not be possible in case of debt. For example, suppose you own 1% of a company for Rs. 100,000. If the company earns a profit of Rs. 15 Lakhs, you earn a profit of Rs. 15,000. And, if the company makes a loss of Rs. 10 Lakhs, you also incur a loss of Rs. 10,000 on your investment of Rs. 100,000.
Should you go with Debt or Equity?
It all depends on your goals and your risk taking capacity! Yes, we always reiterate it because this is something we need to get in our heads very notably-Goal Oriented Planning :) Anyways, taking a step forward towards our personal financial learning. Here are four different categories in which you can divide your goals and then assign debt or equity scheme to them:
Case1) A short term goal with low risk taking capacity. For example, saving for higher education admission fees to be deposited after two years. Here you need money after two years and you cannot afford to take risk with your money. If your investment doesn't perform as expected, you will risk your admission! So, you need your investment return to be certain. Hence, investing in a debt scheme like fixed deposit, recurring deposit or debt oriented mutual fund will make sense here.
Case 2) A long term goal with moderate risk taking capacity. For example, saving for having a luxurious lifestyle post retirement (say after 30 years). Here, you have many years to save. Suppose after doing all the calculations, you determine that you need to earn a rate of return of 15% on your investments to realize the goal of living a luxurious life. And, a rate of return of 8% for a normal life. With debt, there is no chance of earning 15% return. No bank, no provident fund offers this much return as of today. Hence, equity is the only way if the goal has to be fulfilled. So, you can take a little risk here if you do not mind living a normal life instead of a luxurious. If equity performs as expected, your goal will be fulfilled. If it performs lower than expected, you will still have a chance to fallback to normal life.
Case 3) A short term goal with moderate risk taking capacity. For example, saving for down payment of a four wheeler to be purchased after 1 year. If you are flexible to buy a cheaper model instead of your most desired one, then you might think that you can take some risk and invest in equity. But, 1 year is too short for equity. You might just lose majority of your investment if something like recession happens (like 2008-2009), or you might make huge gains (like 2014-15). But these fluctuations are not predictable. If you are not comfortable with very high risk, debt will still make sense here.
Case 4) A long term goal with low risk taking capacity. For example, saving to build a house after 10 years and you cannot afford not having a house after 10 years at any cost. Here, the goal is very stringent which prevents you from taking any risk. You might feel comfortable with pure debt option and not go for any equity at all. However, it's important to understand that equity is not that risky for a longer term. Hence, the requirement of taking a low risk can be met through equity as well, provided you invest for long term. In this case, equity might make more sense to you as it has the potential to provide you higher return than debt without taking much risk.
The above thought process can help you in seeking out right kind of schemes as per your goals and risk taking capacity. Next, it comes down to choosing a particular scheme from the category you have come down to. Like, which equity oriented mutual fund to choose to save for a long term-moderate risk taking capacity goal? We will be continuing with such remaining questions in further posts. Stay tuned!