Question

Would you recommend either debt or equity investment? Explain your answer in detail.

Answer 1

Most investments can be categorized as either debt investments or equity investments. In an equity investment, you buy an asset and your profit is related to the performance of that asset. In a debt investment, you loan money to a person, a business, or a government institution. With a debt investment, your profit is not directly related to the performance of the borrower.

Equity based investments are seen as higher risk and therefore typically earn a higher rate of return over the long term. This is why we even bother with equity-based investments, instead of putting our money into (theoretically) safer debt based investments.Debt based investments are seen as lower risk and therefore usually earn a lower rate of return (again, over the long term). However, debt based investments struggle against a hidden risk — inflation. Many debt based investments offer a rate of return which is less than the rate of inflation. Every day you hold those investments, the real value of your investment capital decreases.

Over time, equity based investments will provide higher rates of return than debt based investments. In the past, investment advisors recommended mixing debt and equity based investments in a portfolio to balance risk and return. This is not recommended as often these days, as most retail investors were led to over invest in debt based investments and experienced significantly lower returns as a natural consequence. A better diversification strategy is to divide your investment capital among various asset based investments.

Debt based investments still serve useful purposes in the financial world. They are often used to temporarily “park” money while waiting for a desirable equity based investment to become available. They are also used by institutional and government investors who are required by law to store funds in the lower risk / lower return investment vehicles.

So the recommendation of investment in either equity or debt depends on risk appetite, time frame and other factors that are personal and professional in nature. If one has low risk apettite or a lesser time frame in mind he should be recommended debt investment. Whereas, if one has a longer time duration and higher risk appetite, historically equity investment will beat debt investments.