“Your financial future is not something that happens to you, it is something that you own”. — Charles Schwab

EQUITY, stock or shares represent an ownership interest. When we buy equity in a company we become a part-owner of the company. Owners of equity participate equally in the profits or losses of the company. Profits can be re-invested or paid out as dividends to equity holders. If a company chooses to re-invest its earnings, shareholders are likely to benefit via capital appreciation. Alternatively, the company can distribute its earnings back to shareholders by means of dividends. Dividends are paid if and when the board, whose directors are usually nominated by the equity holders, decides to pay.

A diversified portfolio will have holdings in the three main asset classes, namely, bonds, stocks and cash. While bonds provide a steady stream of income, the general rule is that equity outperforms bonds in the long term. Usually, the percentage of equity in a portfolio is mainly determined by the investor’s risk appetite. The higher the level of risk an investor is willing to take, the higher the percentage of equity in the portfolio and vice versa. The size of the equity portfolio is also usually determined by the investor’s age as younger investors can withstand more volatility in their portfolio.

The fact that equities outperform bonds makes it a riskier investment. On any given day or over any given period the price of equities moves up and down. The high level of volatility and the fact that unlike bonds, equities have no maturity date or fixed maturity value, adds to risk. This pushes investors to require a risk premium on their equity investment, hence the possibility of earning higher returns than bonds.

There are some strategies to reduce the risk of loss from investing in equities. No investor wants to lose money, but it is advisable when investing in equities to use a stop loss. A stop loss, also known as a stop order or a stop market order, limits an investor’s loss on an equity position. There will be some loss in the event the stock price goes below the price paid, but the extent of the loss can be determined in advance. My rule of thumb is 15 per cent below the purchase price. After all, a diversified portfolio should be able to withstand a 15 per cent loss in one security, other things being equal. If all goes well and the price of the security goes up, then the stop loss price position on the security increases as well.

Buying dividend-paying stocks can reduce the risk of the equity portion of a portfolio. Dividends are only paid from profits. If a company can afford to pay dividends, and still have funds for re-investment, then chances are the price of that company’s stock will be going up. Apple (AAPL) is one such company. The company maintains a large cash position and continues to buy small technology companies to enhance its portfolio, all while paying a quarterly dividend of US$3.05 per stock.

Diversification of the equity portion portfolio is key to minimising risk. Like bonds, equities can be purchased in companies in different industries and in different countries. Investors have a choice of US domiciled companies or emerging market companies.

An investor might be sceptical of taking on equities in their portfolio. Be advised, however, that adding equity to an investment portfolio can drive well-needed portfolio returns. The risk of loss can also be huge. By applying the appropriate strategies above, the risk of loss will be significantly reduced.

Noel Harty is the branch manager for Montego Bay at Stocks & Securities Ltd. Contact: nharty@sslinvest.com