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. If you buy a taco stand, your profit is based upon the net revenue of the taco stand. If you buy a thousand shares of IBM, your profit is based upon the stock dividend which IBM pays (if any) and upon the rise (or fall) of the value of IBM shares.
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. If you buy a $1,000 corporate bond from IBM and IBM makes a record profit, your profit is the same as if IBM has earned no profit at all. On the other hand, there is always a risk with debt investments that the borrower will be unable to pay back the debt. If the borrower doesn’t have the money to pay their lenders or if they file bankruptcy to legally avoid paying their lenders, you could be faced with a complete loss of your investment.
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.
- Mutual Funds
- Real Estate
- Real Estate Investment Trusts (REITs)
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. For example, if you hold money in a savings account which earns 4% interest and the rate of inflation is 5% per year, you lose 1% of the value of your investment every year.
Debt based investments include:
- Savings Accounts
- Certificates of Deposit (CDs)
- Corporate Bonds
- Government Bonds
- Municipal Bonds
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.