Ready to Invest? Know the Difference Between Fixed Income and Equities
By: Barry Choi
Investing may sound complicated to many people, but it doesn't have to be. Sure, there might be some terms and theories that you might not be familiar with, but with a little bit of research, you'll quickly understand the basics.
Regardless of how you want to invest, one of the first things you'll come across is fixed-income and equity markets. These investments have different levels of risk, so how you allocate them depends on what type of investor you are. Let's look at the difference between fixed income and equities and how they affect your portfolio.
Fixed income investments are very safe securities that have a highly unlikely chance of going down in value. They're ideal for people who are looking to protect parts or all of their portfolio. Some fixed income products include:
- Term deposits
- Treasury bills
- Saving accounts
- Money market funds
Since fixed income investments are a less risky option, the return on them is relatively low. However, if you want to earn a higher interest rate, you could shop around to see what products have the best rates.
The interest rate you're paid depends on various factors, but the main consideration is the Bank of Canada's overnight rate. Interest rates have been low for quite some time, so the appeal of fixed income assets has decreased over the years.
That said, fixed income plays a significant role in your portfolio. If you need to keep your money safe, then putting your money in fixed-income assets is ideal. For example, let's say you're going to purchase a house in 5 years. Putting your down payment in a savings account or investing in term deposits would ensure that the principal value of your money doesn't depreciate.
Equity markets refer to the stock market. You can buy individual stocks or funds that have many stocks within them. The most common equity securities are as follows:
- Exchange traded funds (ETFs)
- Mutual funds
When investing in stocks, you have a greater chance of higher gains compared to fixed income products. However, there's also a lot more risk involved. There are zero guarantees with equity markets, so you could lose your initial investment if you choose the wrong products.
The idea of losing all your money is terrifying for most people, which is why mutual funds and ETFs have become so popular. Instead of picking individual stocks, the funds have a basket of stocks managed by professionals or algorithms. How much you'll gain (or lose) depends on how the markets perform while your money is invested.
If you want your portfolio to grow at a reasonable rate, you'll have to include some equities. While some people may be worried that their investments' value can go down, you need to think in bigger terms. If you're diversified, any drop in the market won't matter as long as you don't cash out your investments. Over time, markets will rebound, so you can wait until things recover.
What's the right mix between fixed income and equities?
The mix between fixed income and equity investments is known as asset allocation. For example, if you had 75% in equities and 25% in fixed income, then you'd have a 75/25 allocation favouring equity markets.
The question is, how do you come up with that allocation? There are a few different factors to consider including:
Risk tolerance - Arguably the most critical aspect when it comes to asset allocation, risk tolerance refers to how you would handle things emotionally. Let's say markets dropped 25%. Would you panic and sell, or would you stick to your plan and keep investing? If you knew you would sell, then you have a lower risk tolerance, so having a portfolio that has more fixed income would help you sleep at night.
Time frame - Since markets go up and down, your time frame also plays a significant role. Someone in their 20s who's saving for retirement will likely have no problem going heavy on equities since it'll be decades before they need that money. On the flip side of things, someone in their late 50s will probably want their money in secure investments since they'll need the funds in just a few years.
There's an ebb and flow regarding asset allocation, risk tolerance, and time frames. No one wants to see their money decrease in value, but you can make smarter investment decisions if you understand your time frame and goals.
Seek advice when you need it
If you're ready to start investing, reach out to your financial institution. They'll ask you a few questions which will help them determine your risk tolerance. With that info, they can then recommend funds that fit your profile.
Remember, you need to understand where your money is going. If you don't understand a term that your advisor is using, or you're unsure about certain investments, ask and get clarification. The last thing you want is to be investing in something you know nothing about.