In the context of investing, "equity," or equities, refers to stocks, and "fixed income" refers to bonds or cash investments. The two types of investments tend to behave differently under the same market conditions, providing investors an important form of diversification. Because of their different risk profiles, investors can benefit by putting some money in both types of investments.
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If you own a home, you already understand the principle of equity, which represents the value of your home above and beyond any loan against it. If you own a stock, you also own equity, but in a company. Just like your the value of your house, the value of your stock can go up or down depending on what someone else will pay for it. Though analysts might apply standards by which a stock is valued, the market will ultimately determine its price.
Fixed-income investments provide the investor with a fixed rate of interest, or return. Unlike a mortgage, on which you pay both interest and principal, the borrowing company typically pays only interest until "maturity," the date the loan comes due. Just as your good credit rating might qualify you for a lower interest rate on your loan, so companies with high ratings get to offer lower interest rates on their debt. Poorly rated companies must pay higher interest to compensate for their greater default risk.
Over the long term, stocks tend to move up; the S&P 500 Index, an index of large-company stocks, returned 10.4 per cent a year on average from 1989 to 2008. However, stocks are volatile, meaning their value can swing widely in the short term. As an example, one year during that period, the index had negative returns of 37 per cent.
By contrast, fixed-income investments offer decreased volatility but lower returns. Over that same period, the U.S. Aggregate Bond Index returned 7.6 per cent a year on average, with a worst-year negative return of 2.9 per cent.
Equities come in several flavours. Single stocks, exchange-traded funds or ETFs, and mutual funds are the most common vehicles for equity or stock ownership. For fixed-income investments, look for bonds (corporate, municipal and federal) and CDs, but they can also be found as ETFs and mutual funds. Be sure to understand the composition of an ETF or mutual fund before investing in it, since fixed income and equities can be found in both.
You can allocate your money between equity and fixed income investments to achieve a balance between how much risk you are willing to take and how much growth you want. You can even achieve this balance with only one mutual fund or ETF investment. By allocating your money in this way you achieve the twin goals of diversification, or not putting all your eggs in one basket, and growth with lower volatility (see Resources section).
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