Equities vs Fixed Income

Equity investing is riskier than fixed-income investing over the short term but has the potential for higher returns over the long haul. Fixed-income investments are less risky but have lower returns.

Equity investors seek capital appreciation, which is an increase in the value of their investment over time. Equities may also pay dividends,  which can provide income. In most cases, dividends are smaller than the income that are paid to a fixed income investor. Nevertheless, an equity investor can receive both capital appreciation and dividend income.

Fixed-income investors seek current income, which is the regular interest payments they receive from their investment. Fixed income investors generally do not receive capital appreciation, or the growth in the value of their investment. In most cases, a fixed income investor receives only the income plus the return of the initial investment at a predetermined date.

Capital gains from equity investments are taxed at a lower rate than ordinary income from fixed-income investments as long as they are held for at least 365 days. Dividend income from equities is usually taxed at a lower rate also. Income from fixed income investments are usually taxed at a person’s income-tax rate, which is higher than long-term capital gains rates.

Equity prices can be more volatile than fixed-income prices, which means they can rise and fall more dramatically over short periods of time. If you are investing for a fixed period of time, after which you will need a lump sum of money, then a fixed income investment may be a good choice. If, however, you are investing for a long period of time without certainty about when, if ever, you may need to use the money, then equity investments are a good choice. Equities, over long periods of time, provide higher rates of return than bonds and other fixed income investments. In large part, this is due to their short-term volatility. An investor who can stomach the short-term ups and downs of equity markets can earn potentially higher returns than a fixed income investor who has the income fixed, as well as a date when they can expect the return of their initial investment.

Fixed-income investments can help diversify a portfolio because they tend to move in the opposite direction of equities. This means that when stock prices are falling, bond prices may be rising, which can help offset some of the losses. Importantly, this is not always the case. 2022 began with both equities and bonds declining in value at the same time. A number of factors play into whether equities rise or fall over any short period of time. Fixed income investments also are affected by a number of factors. The biggest factor affecting bond prices is interest rates.

Bonds have a maturity date, which is the date on which the bond issuer must repay the principal amount of the loan. Equities do not have a maturity date, so they can be held indefinitely. An investor who needs a lump sum of money at a certain date in the future may want to invest in a bond that comes due at that time. In the interim, the bond pays a fixed income. At that future date, the investor can rely upon the initial investment being returned to them. Fixed income investors should consider risks that include, the credit worthiness of the borrower, inflation, interest rates and more.

Fixed-income and equites are purchased through investment advisors, stock brokerages, mutual funds and electronically traded funds (ETFs) and notes (ETNs). Sometimes a brokerage will charge an up-front commission. However, in today’s world, the commissions should be fully disclosed and very inexpensive. The internet and preponderance of competition has driven down the costs of investing.

Another key difference between equities and bonds is that bondholders have priority over shareholders if a company goes bankrupt and is liquidated. This means that bondholders will receive their money back before shareholders. This is because bonds are a debt obligation, while shares are equity. As such, bondholders are considered creditors, while shareholders are considered owners.

A key difference between bonds and equities is how they are affected by rising interest rates. As interest rates go up, bond prices go down. For a fixed income investor, they will see the price of their investment decline in a rising interest rate environment. If the bond holder keeps the investment until the maturity date, they will still receive all of their initial investment back, assuming the borrower is still credit-worthy. However, if the investor purchased the fixed income in an ETF or a mutual fund, then the value of the fund will decline as interest rates increase.

Equities are not directly affected by rising interest rates in the same way that bonds are. Some equities do better than others in a rising interest rate environment. For example, equity in a company which has high debt may be more subject to rising interest rates than a company with no, or very little, debt. So the value of the equity for the highly-leveraged company could decline as interest rates rise, or at least not rise as quickly as a company with very little debt. Equities are more prone to volatility than bonds, in large part because equity investors take into consideration countless factors.