Have you ever wondered why equity is universally acknowledged as an asset that delivers superior returns over other asset classes such as debt or gold in the long term?
The answer is a higher risk-reward ratio. Just take the case of your being a salary earner in a company vis-à-vis your running your own business. As a salary earner, while you may get steady payouts and periodic hikes, your upside is essentially capped even when your company does exceedingly well.
On the other hand, as an owner of a firm, you get to enjoy the full benefit of the profits arising from your company. Yes, you may share your profits with other partners; nevertheless there remains unlimited scope for you to gain more. On the flip side, in a downturn, you may also suffer the losses that arise from your business.
Own a piece of the company
Now relate this to owning equities. By owning equity shares of a company, you simply hold part-ownership of a company and thus get a claim over its future earnings, to the extent of your holding.
While a part of such profits would be returned to you in the form of dividends, a good part of the profits is ‘retained and reinvested’ in the company. The price of a share captures your gains as well as the potential profits expected.
By assuming ownership therefore, you are the first-hand receiver of the company’s profits. But this is true when a company is going through a downturn as well.
Therefore, to take on higher risks, an equity investor expects to be compensated by way of higher returns. In other words, the higher return is the ‘premium’ you receive for taking on more risks than other asset classes.
The same is not true of an asset class like debt, where you may enjoy fixed returns but not gain because the bank/finance company is doing well or lending more to customers. Similarly, if you buy a property, the bulk of the profit is made by the developer; or at best a private equity investor; what you enjoy later is perhaps the residual capital appreciation.
With gold, yes, you may own it, but given that gold does not have any commercial usage to it, there is no imputed value that you can assign to it. Mere demand factors will drive prices, not backed by any sound business fundamentals.
No reinvestment risk
The other reason why equities manage to deliver more in the long term is that they do not exhibit the kind of reinvestment risk that asset classes like debt do. You may invest at 9% in a fixed income product and then on its maturity, realize that the prevailing rates have been reduced to say 7%.
With equities, you invest in the business prospects of a company and are, as such, not limited by such risk, as long as the company holds good prospects.
Also remember, investing in a share of company does not literally require you to run a company. There are experts – the management – to do the job for you; unlike running your own business. Hence, you actually get to enjoy the monetary benefits arising from being an entrepreneur, without fully assuming the role.
Look at your salaried job as your fixed income portfolio (not without risks though!) and an investment in equities as the asset that satisfies and adequately pays off your entrepreneurial spirits. Now that makes for a reasonably balanced portfolio!