What are Securities? Equity vs. Debt Investments

A security is a tradable financial asset that can be bought or sold in financial markets. Securities cover a wide range of assets, but most fall into two primary categories: equity securities and debt securities. Each plays a different role in how investors pursue growth and try to manage risk.

Equity securities represent an ownership stake in a company. When you invest in equity securities, your return is typically tied to the company's performance and growth. By owning a share, you own a small fraction of the company's assets and have a claim on its future earnings.

Examples include:

• Common stock, which may provide price appreciation and dividends. Appreciation is when a stock you own goes up in value. If you bought the stock at one price, and the price went up, you could then make money by selling the stock to another investor at a higher price. A dividend, on the other hand, is a payment—representing a portion of a company's earnings—that some companies issue periodically to shareholders.
• Preferred stock, which typically pays fixed dividends and doesn't offer the same potential for gains that common stocks do when, say, a company reports blowout earnings. Rather, with preferred stock, the yield is your return. Companies issue preferred stock as another way to raise money. Most corporate capital structures include senior secured debt, senior unsecured debt, subordinated debt, preferred stock, and common stock. Investors get paid in that order in the event the company goes bankrupt and is liquidated, assuming there's anything left for holders of preferred and common stock.
• Equity funds, such as mutual funds and exchange-traded funds (ETFs), that invest in a diversified portfolio of stocks. ETFs trade like stocks and are bought and sold on a stock exchange, experiencing price changes throughout the trading day. This means that the price at which you buy an ETF will likely differ from the prices paid by other investors. Mutual funds are generally bought directly from investment companies instead of from other investors on an exchange. Orders are executed once per day, with anyone who invests on the same day receiving the same price.
• Real estate investment trusts (REITs), which own and operate income-producing real estate. REITs typically invest in commercial properties, such as shopping centers and office buildings. They are required by the IRS to pay out at least 90% of their taxable income to unit holders each year, money that is often exempt from corporate income taxes. REITs can provide income potential, inflation protection, and diversification.

Investors typically invest in equity securities for growth potential over the longer term. Historically, equities have delivered better returns than some other asset classes, but with a correspondingly higher risk of volatility and losses.

Debt securities—often referred to as fixed income securities—represent a loan made by an investor to a company, government, or other entity. In return, the issuer typically agrees to pay interest in the form of coupon payments and repay the principal at a set date.

Common examples include:

• U.S. Treasury securities, which are issued by the federal government.
• Municipal bonds, which are primarily issued by state and local governments.
• Corporate bonds, which are issued by companies.
• Certificates of deposit (CDs), which are issued by banks and credit unions.

Investors typically use debt securities for income. Having a steady stream of income in a portfolio—the kind that coupon payments can provide—can help stabilize a portfolio during a stock market downturn. These payments can be either at a fixed rate or rates that float along with fluctuations in a benchmark rate. However, returns may be more limited.

Debt securities also carry risk, including price risk and credit risk, depending on the type of instrument and the issuer. They aren't immune to sharp price declines.

Changes in interest rates can create price risk. Bond prices and interest rates are intertwined, almost by definition, as the movement of the latter directly impacts the price action of the former. The relationship between rates and fixed rate bond values is simple: When rates go up, bond prices down. (And the opposite is also true: When rates go down, bond prices go up.) Why? Fixed rate bonds can become more or less attractive depending on how their interest payments compare to those available from bonds issued at new rates.

Credit risk is the chance the borrower may not pay back the debt when due.

Securities are typically issued in a primary market and then investors can buy and sell them to each other on the secondary market. These markets are regulated by organizations such as the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), which help promote transparency and protect investors.

When a corporation or government needs to raise capital, it issues new securities directly to investors. For example, when a company wants to raise money, it might sell shares to members of the public during an Initial Public Offering (IPO). Similarly, when a municipal agency wants to raise money to build a school or airport, it might sell municipal bonds. In both cases, the proceeds of the sale go to the issuers.

After the securities are issued, investors can buy and sell them in financial markets. On exchanges such as the New York Stock Exchange (NYSE) or Nasdaq, investors trade existing securities, and money flows between buyers and sellers, not to the company that originally issued the security.

Every security possesses its own potential for risks and returns. Equity securities offer the opportunity for long-term growth and capital appreciation, while debt securities can provide income and help diversify a portfolio. By combining these different types of securities, investors can align their portfolios with their financial goals, time horizon, and risk tolerance.