Investing for Beginners: The Two Major Investment Categories

Posted by under General Information, Investing . Published: July 30, 2020

More and more investments are becoming accessible to Filipinos, and more and more Filipinos are investing.

From time deposits to retail treasury bonds, from local and global stocks to real estate investment trusts, from mutual funds to cooperatives–the list of investments that are within reach for ordinary citizens have become much longer than it was ten or even five years ago.

Along with the growth of investment diversity, comes wider confusion for beginner investors.

Which one gives the best returns or have the lowest risks? Which ones are legit opportunities and which ones are investment scams?

The concerns and questions are increasing, as evident by the messages and emails that I’ve been getting as of late.

Thus, for today, I’d like to take a step back and give new investors foundational knowledge on two major investment categories.

And just like your great grandparents to your family, most if not all investments today can be traced back to these two basic markets–the debt market and the equity market.

The Debt Market

A friend is borrowing money from you. You lend him money but he needs to pay you extra, or more appropriately, interests for the loan. For extra security, you also asked him to give up his smartphone as collateral.

Investments in debt securities work the same way. You are lending out money, in exchange for interest payments. In the worst-case scenario that they can’t pay, and if it’s stipulated in the agreement, then you can repossess their assets or at the very least, have priority on being paid when they liquidate their assets.

Your bank savings account is a debt security investment because the bank is paying you interest for using your money. Time deposits work similarly. Government and corporate bonds are debt securities as well.

Investments that fall under the debt category or the debt market:

  • Have low to moderate risks – there are less fluctuation and lower chances of losing money
  • Have small to medium-size returns – under ordinary circumstances, you’ll earn less than 10% per year

Reasons for investing in debt securities:

  • You want to beat inflation over a short or medium-term period, around 5 years or less.
  • You want to receive regular cashflow or a fixed income, which are the interest payments.

The Equity Market

A friend is putting up a business and is asking you for capital in exchange for part-ownership of the business. If you agree, then you’ll earn a portion of the income from the business, which is called dividends. And if you want your money back, then you can sell your portion of the business to your friend, or to someone else.

This is how investments in the equity market or more popularly, the stock market work. When you buy shares, you are becoming a part-owner of the company. You can earn dividends, and ultimately, if you want your money back, you can just sell your shares to someone else. And if the business has grown since you bought the shares, then the price of those shares would have increased as well and thus giving you some returns.

Aside from the stock market, investing in real estate works similarly. You can create a business and use your property for rental income, or simply sell it to someone else willing to pay you with some profit.

Investments that fall under the equity category or the equity market:

  • Have moderate to high risks – there are more fluctuation and higher chances of losing money
  • Have medium or large-size returns – under favorable circumstances, you’ll earn more than 10% per year

Reasons for investing in equity investments:

  • You want your capital to increase significantly over the medium or long-term period, around 5 years or more.
  • You want to receive cashflow in the form of dividends, which are never guaranteed but are normally much higher than what debt securities offer.

Let’s make it a bit more complicated…

To review, in debt investments, someone is borrowing your money and you earn interests and there’s a promise to give back your money after a certain period.

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For equity investments, you are becoming an owner of a business or an asset and you earn income in the form of dividends and the only way to get your money back is when you decide to give up that ownership and sell your shares.

Now, when you invest in a unit investment trust fund (UITF) or a mutual fund, are you making a debt investment or an equity investment?

If you’re familiar with these, then you’ll realize that it falls under an equity investment. You won’t earn dividends because those are usually reinvested back to the fund. However, the only way to get your capital is to sell back your units or shares to the fund.

That’s why when you have fund investments, you’ll most likely receive invitations to stockholder or shareholder meetings. Because that’s when the board updates you of what they’ve been doing, which is your right as part-owner of the fund.

There are, of course, funds such as bond funds or fixed-income funds, which are technically still equity-type of investments, but behave like a debt investment because it carries low to moderate risks and gives low to medium-size returns.

How about the very popular Pag-IBIG MP2 program? Is this a debt-type or an equity-type of investment?

It falls under the debt category because you are not becoming an owner of anything. You are lending your money to the Pag-IBIG fund, and you’re earning regular interests from it and more importantly, there’s a promise to give your money back in the end, whether you like it or not.

Pag-IBIG MP2 may call it dividends, but by our definition and by the nature of why you’re receiving it, it is in fact, interest payments.

Why it’s important to know this

Once you understand these two basic markets, it’s now easier to evaluate investment opportunities and decide for yourself if it’s something that fits your financial goals or not.

People have been asking if they should invest in REITs or not. Real Estate Investment Trusts fall under the equity market. You are buying shares and becoming owners of a real estate business.

If you’re looking for an investment with low risk and that which will give regular cash flow, then a REIT investment is not for you because what you’re looking for is exactly what a debt-type of investment offers.

Moreover, knowing the difference between debt securities and equities provides a tool to analyze if an investment is legitimate or too good to be true.

For example, a company is offering an investment opportunity where you’ll earn regular interests for an unlimited length of time or for as long as you are invested. Is this a debt or an equity type of investment?

Because there’s no “end of tenure” or a promise to give back your capital after a certain period, then it must be an equity-type of investment. This means you are buying shares of the company and becoming a part-owner of it.

Thus, you should now check if that business is a registered company with proper licenses to operate because that’s the only way they can legally sell shares of the business to the public. If not, then it’s probably a scam.

Final Thoughts

There are thousands of investments out there. Some can easily be categorized under the debt market or the equity market. Others are more difficult to discern, and could even be a hybrid of the two.

As a beginner investor, my recommendation is to stick to investments that you can clearly understand which category among the two it belongs to. And always invest according to your financial goals, and not solely based on their potential returns.

Fortunately, in most cases, you don’t even need to put money in complicated types of investments. Because as I’ve seen from many financially-successful individuals, simple and straightforward investments in the debt and equity markets are more than enough to build your wealth.

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