Equity Investment: How Much Should You Risk?

Investing in equity can be a thrilling yet challenging experience. Equity investment is when you buy a partial share of a company, making you a part owner of that company. The simplest way to understand equity is to see it as a company's fundraising activity, where instead of taking out a business loan, the company collects money from the general public. Equity investments can be made through stocks or mutual funds. Stocks offer high return potential and a large universe of stocks to choose from, but they require more careful risk management. Mutual funds, on the other hand, offer professional management, diversification to bring down risks, and a relatively small ticket size. When deciding how much to invest in equity, it's important to consider your financial goals, risk tolerance, and current market conditions.

How much equity should I ask for?

Asking for equity in a company can be a tricky business, especially if you are new to the industry. There is no one-size-fits-all answer, as each opportunity is unique. However, here are some factors and guidelines to consider when determining how much equity to ask for:

• Role and Remuneration: Your role in the company and the remuneration you receive will impact the amount of equity you can ask for. For example, a CEO typically becomes a major shareholder in a startup, while other C-level executives receive lesser equity that vests over time.
• Experience and Track Record: If you have significant experience or a successful track record in the industry, you may be able to ask for more equity.
• Company Valuation and Revenue: Consider the current and potential value of the company. If the company is generating significant revenue or has a high valuation, you may need to adjust your equity expectations downwards.
• Investment and Investors: If the company has received professional investment from venture capital firms or strategic partners, this may affect the amount of equity available for other stakeholders.
• Salary and Benefits: Remember that salary and equity are exchangeable and negotiable. You may be able to get more equity by accepting a lower salary and vice versa. Consider the benefits offered by the company as well, as these may impact the overall compensation package.
• Company Growth and Potential: Join a company with high growth potential and a strong mission or product line, even if profits are not yet substantial. This could be an opportunity to acquire more equity, as the company's value is expected to increase over time.
• Vesting Schedules and Cliffs: Be mindful of vesting schedules and cliffs, which determine how and when you receive your equity allocations. A vesting schedule grants you small portions of your total equity over time, while a vesting cliff means you receive none of your equity until a set period, after which you get it all at once.
• Capital Gains Tax: Remember to consider the tax implications of equity grants. As the company grows and increases in value, you may be subject to capital gains tax on the difference between the original and current valuation of your equity stake.
• Your Value-Add: Finally, think about the value you bring to the company and how much your contributions are worth. This will help you negotiate a fair equity stake that recognises your importance to the organisation.

What are the benefits of investing in equities?

Investing in equities can bring a range of benefits, from high returns to tax advantages. Here are some of the key advantages:

High Returns

Equities offer the potential for high returns, maximising your investment. This is achieved through capital appreciation and dividend income. Capital appreciation occurs when the price of a share increases, and you can sell it for a profit. Dividend income is the distribution of surplus profits by a company to its shareholders, providing an additional income stream.

Beating Inflation

Equities have historically outperformed other investment options, such as bank fixed deposits, and have been shown to beat inflation over the long term. This facilitates wealth creation and helps to protect your money from losing value due to inflation.

Tax Advantages

Equity investments often come with tax benefits. For example, long-term capital gains (LTCG) up to a certain amount may be tax-exempt, and short-term capital gains (STCG) are typically taxed at a lower rate than other investments, such as debt or gold.

Liquidity

Stocks are generally considered liquid assets, meaning they can be easily converted to cash. Shares can be sold on any trading day, and the money will typically reach your bank account within a few days. Additionally, shares can be used as collateral for loans, providing another source of liquidity.

Diversification

Equities allow for diversification of your investment portfolio, reducing the risk associated with any single investment instrument. By investing in different companies and sectors, you can minimise the impact of market fluctuations and improve your overall investment performance.

Control and Voting Rights

When you invest in a company's equity, you become a partial owner and gain voting rights. This gives you a say in the company's decision-making and allows you to influence its direction.

How can I invest in equities?

There are two main ways to invest in the stock market: either by buying shares in a company directly or investing indirectly. When you buy shares in a company, you are purchasing a small part of the company, or equity. This means you own a fraction of the company's value and, depending on the type of stock, may have voting rights in company decisions and be eligible for dividend payments.

The most common way for a company to offer shares is through an Initial Public Offering (IPO). This is when a company sells shares in its business to the public for the first time. The number of shares issued, multiplied by the price for which they sell, determines a company's market capitalisation, or 'market cap'.

Shares can be bought and sold on a stock exchange such as the Australian Securities Exchange (ASX). Most trading platforms charge a share dealing fee for buying or selling shares, often a flat fee of between $5 to $15 per trade. You may also have to pay an annual platform fee for holding shares, typically charged as a percentage of the value of your shares.

If buying and selling individual shares sounds too risky, you can invest in 'collective' investments, including investment funds and Exchange-Traded Funds (ETFs). These vehicles spread investors' money across a wide range of securities, reducing risk through diversification.

Another option is to hold these investments in your superannuation, either by choosing to have an allocation of your super put towards equities or by using a self-managed super fund (SMSF) to buy them yourself.

Before investing in equities, it's important to understand your investor personality. Ask yourself: "What kind of investor am I?", "How much risk am I willing to take?", and "How much capital do I want to allot?".

It's also a good idea to take advantage of technology. Robo-advisor services use machine learning and algorithms to help investors make better decisions, and there are many money management apps to help you track monthly investments and expenses.

Finally, remember that salary and equity compensation are two different things. Salary is a fixed amount of money, while equity is a percentage of the company that you own. You can't have one without the other, so it's best to negotiate both together.

What are the risks of investing in equities?

Investing in equities comes with a multitude of risks that investors should be aware of before committing their money. Here are some of the key risks associated with equity investments:

Market Risk

Market risk refers to the volatility and unpredictability of stock prices, which are influenced by various market and economic factors, both locally and internationally. Stock prices can be subject to rapid and significant fluctuations, and investors may lose some or all of their investment due to market risk.

Interest Rate Risk

Changes in interest rates can impact stock prices to varying degrees. For example, if the local currency is pegged to another currency, interest rate shifts in one country can directly influence rates in the other.

Global Risk

In today's globalised economy, stock markets are highly interconnected and influenced by economic events worldwide. Therefore, investors are exposed to economic risks from all major markets, and these factors should be considered in their risk assessment.

Business Risk

The performance of the company in which an investor buys shares can also introduce risk. For instance, poor management decisions, industry slowdowns, or increased competition can lead to a severe decline in profits or even bankruptcy.

Corporate Misgovernance

Sometimes, companies may make decisions that are detrimental to shareholders' interests, such as improper management practices or unfavourable transactions. While regulators typically do not intervene in commercial decisions, investors should be cautious about the potential impact on their investments.

Trading Suspension

A stock may be suspended from trading to prevent insider dealing and ensure informed trading. During this time, investors cannot buy or sell the stock, and its price may still move due to market and business risk changes.

Liquidity Risk

Liquidity refers to the ease of buying and selling stocks without impacting the stock price. Some stocks may be hard or costly to liquidate, particularly those with low capitalisation.

Currency Risk

Changes in currency exchange rates can affect the value of an investment, especially when investing in overseas markets. If the local currency appreciates against the invested currency, translation losses can occur.

Credit Risk

A company may be unable to pay its debts, which can impact its ability to operate and affect its value.

Political Risk

Political changes or instability in a company's operating country can influence its returns.

Economic Concentration Risk

If a company's value is heavily concentrated in a single entity, sector, or country, it is vulnerable to disproportionate harm if that factor's value drops.

Inflation Risk

Rising inflation can hurt a company's value and dilute its worth.

Sector-Specific Risk

Certain sectors may experience periods of weakness or malaise due to external factors, such as negative news or industry-specific events.

Timing Risk

Not all sectors follow the same price cycles, and the risk arises from buying or selling a share at the wrong time. Understanding business cycles and sector performance during different phases can help mitigate this risk.

It is important to remember that while these risks exist, they can be managed through careful planning, diversification, and a thorough understanding of one's risk tolerance and financial goals.

How much should I invest in equity?

The amount of money to invest in equity depends on several factors, including your financial goals, risk tolerance, age, and current market conditions. Here are some guidelines and considerations to help you determine how much to invest in equity:

Rule of Thumb

A common rule of thumb for equity investment is 100 minus your age. For example, if you are 35 years old, this rule suggests investing 65% of your money in equity. However, it is important to note that this is just a guideline and may not be suitable for everyone.

Financial Planning

It is crucial to perform a comprehensive financial planning exercise to determine your financial goals, risk profile, expected returns, and the returns you should earn. This will help you devise the best asset allocation strategy, which may include equity investments.

Risk Tolerance

Equity investments carry inherent risks due to the volatile nature of the stock market. Before investing in equity, assess your risk tolerance and ensure you are comfortable with the potential for short-term losses. Diversification and long-term investing can help mitigate some of these risks.

Time Horizon

Equity investments are typically suitable for long-term financial goals. If you are investing for the short term, such as saving for a wedding or education, equity investments may not be the best option. Consider your time horizon and adjust your equity allocation accordingly.

Investment Opportunities

When deciding how much to invest in equity, consider the investment opportunities available to you. Research and analyse different companies, sectors, and investment vehicles to identify those that align with your investment strategy and goals.

Diversification

Diversification is a crucial aspect of investing. Spread your investments across different asset classes, sectors, and companies to reduce risk. Remember that investing in equity is just one part of a well-diversified portfolio.

Investor Profile

Understand your investor profile by asking yourself questions like "What kind of investor am I?" and "How much risk am I willing to take?". This will help you determine the types of investments that suit your risk tolerance and financial goals.

Professional Advice

Consider seeking advice from a financial advisor or investment professional. They can provide personalised guidance based on your financial situation, goals, and risk tolerance. Their expertise can help you make more informed decisions about your equity investments.

Monitoring and Adjustments

Investing in equity requires ongoing monitoring and adjustments. Stay updated with financial news, market trends, and the performance of your investments. Regularly review and rebalance your portfolio to ensure it aligns with your investment strategy and goals.

In conclusion, the amount of money to invest in equity depends on various factors, and it is essential to carefully consider your financial situation and goals before making any investment decisions. Remember that investing in equity carries risks, and it is crucial to do your research and seek professional advice when needed.

Frequently asked questions