Friday, June 26, 2009

Difference between Debt & Equity Investing

The basic difference between debt and equity would be the ownership level. Let's take an example where you invest in me.


If you give out some money to me and expect that I return the money along with interest that I pre promise, that would be a debt investment. I'm indebted to you but since I have promised you a return with interest, you don't actually own me.


In another case, you give me money at your own risk. But you trust me/hope that I'll be a billionaire in the future and I'll payback from my profits. The more profits I make, the more you do. If I am bankrupt, you don't get anything back.  And so you have invested in my equity. By trusting me, you own me in a way!


In other words, by investing in a debt instrument such as a bond, you are guaranteed the principal of the bond, plus any interest that is owing.


However, for equity investors, you become an owner. As such, you also take on the risk of the company not being a success. Just as a small business owner has no guarantee of success with each new venture, neither is a shareholder.  As a shareholder, if the company is successful, you stand to make a lot of money. On the flipside, you stand to lose a lot of money if the company is less than successful.


Now debt and equity is just a classification of financial products and not a product by itself. So let me share the products available within the two classifications:


Equity: You can own any stock on the Stock Exchanges and you have invested in an equity product. If you invest through Mutual Funds who have schemes for equity. Even ULIPs invest in equity and so part of your Insurance buy goes to equity. The NPS also invests in equity.


 Shares come in different sizes and categories. There are large, mid and small caps and there are penny stocks. As a beginner, you can invest in large and mid cap companies and only after you gain experience, you can consider investing a small portion in small caps and hot penny stocks. These are the riskiest but if handled adroitly, give the largest returns. However, it needs expertise and nerves of steel.


Debt: Mutual Funds also have debt funds where you can invest. Some people may find investing in bonds simpler than investing in stocks. Your friendly neighbourhood financial advisor can provide you with government bonds like NSC/KVP. Your banker provides you with Fixed Deposits and PPF accounts. You can also pick up some highly rated corporate bonds.


Then there are hybrid funds where the Mutual Funds invest a part in equity and a part in debt.


To compare debt and equity, you need to consider the risk and the reward tradeoff. But that I guess would be another post.


Would you like to add your thoughts on this? Welcome and Thanks.


Ranjan Varma
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