Types of Equities and Their Risk Profiles
The equities (also known as stocks or shares) of a corporation are a type of financial security that denote ownership in a business.
How Are Equities Bought and Sold?
Equities are bought and sold using a stock exchange (such as the London Stock Exchange or New York Stock Exchange). They are usually bought by stockbrokers and form the basis of an investor's portfolio. All transactions on the stock exchange should conform to government regulations.
A stock exchange is a method through which companies raise capital through selling equities to the investing public (in contrast to borrowing, where capital is raised through a credit or a loan).
How Are Equities Priced?
Fundamentally, share prices are determined (in common with most other markets) by supply and demand.
Once a company goes public and is listed on the stock exchange, generally speaking, the most recent price paid becomes the market value. If the buyer pays more, the market value goes up.
A company’s worth or total market value (market capitalisation or ‘market cap’) is calculated by multiplying the share price by the number of shares outstanding.
Therefore, the price of a company’s equities is relative to its worth, representing a percentage change in the market cap at any given point in time. A change of even £0.01p per share can cause a dramatic change in the value of a portfolio if one single investor owns one million shares.
Initial Public Offering
When a company first goes public and is listed on the stock exchange, an investment bank will use valuation techniques to determine a company’s value, how many equities will be offered to the public and at what price. This is known as an initial public offering or IPO and determines a company’s market cap.
What Factors Make Share Prices Go Up or Down?
Share prices are primarily affected by two factors:
- The performance of the company
- The wider environment
Companies have to publish their financial results and provide trading updates that give an insight into performance. Companies are also obliged to publicly notify events that could affect the price of equities, such as the launch of a new product, takeover bids and so on. All of this provides information to investors as to how well a business is doing.
This information will be viewed alongside the wider market environment. In times of financial uncertainty, investors may have less confidence that a company will do well and may raise questions about a company’s profitability. This may lead to reduced demand for equities and, as a result, prices may fall. Tough conditions may even lead to companies who are doing well to experience a fall in their share price. Likewise, a buoyant market may see companies who are doing less well increase their share price.
The sector performance more generally will also affect prices. For example, over the last decade, tech and cloud-related companies have boomed whilst publishing companies have struggled. These factors specific to each industry will play a part in rising or falling prices.
Large-Cap vs Mid-Cap vs Small-Cap
A company’s market capitalisation or ‘market cap’ is a company’s worth and is calculated by multiplying the company’s share price by the number of shares outstanding. Market cap reflects only the share value of a company and is used in the ranking of companies by size (and thus also the ranking of stock exchanges).
In general, large-cap (or big-cap), mid-cap and small-cap refer to the size of the company.
Different indexes use different numbers to divide companies into large, mid and small-cap, with others also using additional terms such as mega-cap, micro-cap and nano-cap as further categories of company size. As such, there is no one definition or value of large, mid or small-cap.
Small or mid-cap equities can become large-cap equities in time, and large-cap equities do not guarantee a bigger return on investment. The definitions evolve as time passes, as the terms are relative to themselves. A company defined as big-cap 30 years ago may now only be small-cap.
- Large-Cap. Large-cap companies are the biggest players or the largest publicly traded companies. Generally, large-cap companies are the market leaders or one of the top three performers in the sector and are commonly household brands. Large-cap or big-cap companies are sometimes known as ‘blue-chip’.
Large-cap companies are companies that are perceived as well established, safe, stable, profitable in both good and bad times and are often deemed to be a low-risk investment as people will continue to buy their products despite difficult economic market conditions. Large-cap companies typically have a market capitalisation in the billions, commonly over $10 billion.
- Mid-Cap. Mid-cap equities are shares of public companies usually with market capitalisations between $1 billion and $5 billion, or $2 billion and $10 billion, depending on the analyst.
As you would expect, mid-cap companies are established companies in the process of expanding and operating in an industry expected to experience rapid growth. Investors find mid-cap companies beneficial as they have the potential for growth, but this must be balanced against their higher risk profile as they are not so well established as a (usually) safer large-cap company.
- Small-Cap. Companies classified as small-cap usually have a market cap of somewhere between $300 million and $1 billion. Small-cap companies will usually be either newly established, operating in a niche market or serving a new industry, all of which make them considered a higher-risk investment and more prone to falter in a poor economic climate.
Growth, Value and Income Equities: Risk Differences
Investors typically invest for two reasons – either to make income from dividend profits or to benefit from being able to later sell their equities at a higher price. Some investments will happily offer an investor both but typically an investor will have some of each type of share in their portfolio.
- Growth Equities. These are, as the name suggests, equities held in companies that are expected to grow or have the potential for growth. These companies often operate in emerging industries and plough revenue back into expansion. Growth companies are naturally more prevalent in some sectors, such as biotechnology, but all sectors have growth companies.
Growth equities can be a risky choice for investment as outside or unexpected factors may impact growth.
- Value Equities. Investors look for investment potential in companies who are temporarily performing at an under-value. This means that the equity price is valued lower than would normally be estimated based on financial status and trading indicators. This may be because of a technical reason such as high dividend payout ratios or, perhaps, an issue of public perception which does not affect the operation (and therefore profit) of the company.
Whatever the reason, investors take the risk that the dip will be short-lived and the price will soon increase. Value equities are typically those of well-established companies and are perceived as less risky than less established companies.
- Income Equities. Investors choose income equities for a steady income received from, they hope, higher than average dividends.
When assessing whether a company will pay out high dividends, investors calculate a company’s dividend cover to see how robust and reliable its shareholder payouts will be. This is calculated by dividing a company’s earnings per share (EPS) with its dividend per share (DPS). As a rule of thumb, a dividend cover of two or more generally points to a safer bet; lower than 1.5 may be cause for concern.
10 Risk Factors Affecting Equities
As we have explored above, the price of equities may vary depending on variables relating to the company and various external factors including the instability of the global economic market.
There is always the intrinsic risk that the company will go out of business and take with it any investment. Investments in large corporations unlikely to fold are arguably ‘safer’ but the financial reward may be smaller.
Investing in equities carries risk and investors need to balance this risk against the potential rewards. All investors or fund managers must carry out risk management to identify, analyse and, where appropriate, accept or mitigate against objectives and risk tolerance.
Here are some of the most common risk factors that affect every type of equity regardless of sector:
1. Exposure to Fortunes of Market and Wider Economy
The market or wider economy may collapse, or just ‘go bad’ if there is a financial downturn. It could be due to a specific event (such as a terrorist attack) or the impact of a specific set of circumstances (such as the subprime mortgage market crisis which led to an international banking crisis followed by a global financial recession).
This can lead to a so-called ‘bear market’ in which prices can fall 20% or more.
2. A Drop in Investor Confidence
When investors believe something is about to happen they will take action, such as selling off their equities to avoid losses, which can impact prices. This can also signal the onset of a bear market.
3. Liquidity Risk
Liquidity risk is the risk that an investor may not be able to sell assets quickly enough without a loss of capital or a reduction in price. If there are few buyers for your type of share, they may take longer than expected to sell and they may sell at a lower price.
4. Lack of Diversification
Investors manage risk by ensuring that investments are spread across a diverse range of products and markets. By investing in different areas and types of assets, investors hope to both maximise investment and reduce the risk of loss.
5. Currency Exchange Risk
By contrast, currency exchange risk is an example of systematic market risk that cannot be eliminated or reduced.
Put simply, when an asset or investment is held in a foreign currency, there is always a risk that the currency will lose value due to exchange rate fluctuations against the investor's domestic currency.
6. Poor Management (of Funds or Companies)
Poor risk management by an investor or fund manager, such as failing to identify risk, sub-standard analysis, inability to adequately mitigate and so on, can lead to a loss.
Poor risk-management decisions can escalate rapidly with catastrophic consequences. The financial crisis of 2008 can be traced back to the poor decisions made in the subprime mortgage market.
One key example was extending mortgages to those with poor credit ratings, which were then compounded by the repackaging of those mortgages and excessive investing in those repackaged mortgage-backed securities.
7. Investment Fraud
Investors should always be aware of the risk that some equities may either be worthless or not actually exist – and therefore any money invested might fall straight into the hands of the criminal who has set it up to catch them out.
Often these schemes promise returns which are too great. Risk can be mitigated by always seeking independent advice (and legal advice if required) and ensuring the firm used for investments is both on the FCA register and allowed to give financial advice.
8. Horizon Risk
Investment horizon is the length of time that an investor proposes to hold a portfolio or investment. Generally speaking, if an investor plans to hold a portfolio for several decades, they would probably invest in more high-risk products early on and, as the length of the horizon reduces (i.e. approaching retirement), would seek to move investments to less risky products to minimise losses.
A risk with a long investment horizon is that an unforeseen event, such as a change in circumstance or market event, may force an investor to sell to create liquidity, but not at the predicted time or price, causing a loss.
9. Investor Dilution
If a company offers additional equities to market, perhaps to raise revenue or fund a new venture, buy a competitor, or launch a new product, the short term result is that the existing value and proportional ownership reduces.
It is not automatically a bad thing: if the company is successful in its aims, profits will rise. However, investors should be aware that it can lead to a decrease in value.
10. Changes in Law, Regulation or Government Policy
So-called legislative risk is the risk that the government may alter laws or bring in new tax policies that change the basis on which previous investment decisions have been made.
Legislative risk is viewed as a huge risk by investors – what was given as a competitive advantage by one government may then be taken away in an increase or change in the tax position by the next.
The risks of investment are many and varied and there are no guarantees, which is also what makes investing in equities such a compelling prospect. It is possible to take steps to mitigate loss, but investors should ensure they are dealing with reputable institutions and experienced professionals.
The biggest returns usually follow the greatest accepted risks, and it wise for investors to view investments over a long investment horizon and invest in a diverse portfolio of products that are reviewed regularly.
WikiJob does not provide tax, investment or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.