If you are new to the investing world, you might often hear the terms ‘equity’ and ‘debt’. Have you ever wondered what exactly are debt and equity investments? Well, we’ll learn those financial jargons today and also know the key differences between debt and equity.
What are Debt and Equity?
Debt and equity are actually two different ways to raise money for a business. Suppose you run a small grocery shop. At one point, you see growth opportunity in the business and you wish to expand your shop to a bigger store. You need money for that. Now you have two options – debt and equity.
Debt means loan. You may take a loan from a bank or other financial institutions, and you have to pay a fixed rate of interest on that loan. You also have to repay the principal amount along with the interest within a time-frame.
Another option you have is equity. Equity simply means a share in the business. You take money from a friend or relative (or, any other person) and give him a share in your business. Suppose, your friend gives you 5 lakh rupees and agrees to have a 25% share in your business. You don’t have to pay any interest to the friend. You don’t even have to return the principal amount. But you have to give 25% of profit share to your friend every month. And if your business is at a loss, your friend also take the loss. It’s as simple as that.
What are Debt and Equity Investment options?
Now, from the investor’s point of view, debt and equity are two different kinds of financial instruments where you can invest your money.
When you lend (invest) your money for a fixed rate of return, that is called a debt investment. For example, if you put your money in a bank fixed deposit for a 6% return, you are basically lending your money or giving a loan to that bank for a fixed rate of return, that is 6% here.
So, Fixed Deposits, Employees’ Provident Fund (EPF), Public Provident Fund (PPF), LIC and other insurance policies, Debt mutual Funds, Govt. securities, corporate bonds etc. all are debt investment options where you get a fixed rate of return. In debt investment the risk is less and the return is almost guaranteed.
Now, let’s have a look at equity. When you invest your money in a business for a share of that business, that is called equity investment. In equity, you don’t get a fixed rate of return. You don’t even get guarantee of any return. If the company you have invested in makes a profit, only then you get a profit share, if the business makes losses, you lose money too.
So, in short, equity investment is a more risky investment but also has the potential to generate higher returns in the long term. Stocks, Exchange traded funds (ETFs), equity mutual funds are the major equity investment instruments.
What are the Key Differences between Debt and Equity?
- Debt investment is a low-risk investment option whereas equity is a high-risk instrument.
- In debt investment, return is almost always guaranteed, and you don’t generally lose money, but in equity there is no guaranteed return and investors lose a lot a money too.
- In debt instruments, you get a fixed rate of return whereas in equity the return rate is not fixed. In equity, the return depends on the business performance, overall economic conditions of the country, holding period of the investment etc.
- Debt investments are not volatile and don’t depend on market conditions. But equity investments are volatile and fluctuates depending upon the market conditions and demand-supply equation.
- Historically, debt instruments have generated low returns (4-8%) whereas equity investment generally generates higher returns (12-15%).
- Debt instruments are for both short-term and long-term investments whereas equity is advisable only for long-term investments.
So, you see, debt investment options are generally low-risk low-return instruments. On the other hand, equity instruments are high-risk high-return kind of things. Debt investments protect your wealth and give stability whereas equity brings growth.
Where Should I Invest? Debt or Equity?
Frankly speaking, no investment option is 100% safe and hence everyone should have a diversified approach to investments. In short, you should invest in both debt and equity instruments to achieve financial freedom. Here, how much allocation you should give to debt and how much to equity investments depend on your risk profile and financial goals. As a general thumb rule, your debt allocation should be an equal percentage to your age. The rest should go into equity. A 30-year old person can invest 30% of his/her savings in debt instruments and 70% in equity, whereas a 50-year old should park 50% of his/her money in debt and 50% in equity.