The Unique Advantage Of Equity Investment

Due to the compounding effect, equities can create phenomenal growth — but only if there is a source of growth.

- Terry Smith

Investing in equities presents one with a unique advantage over other asset classes, which in my experience is rarely understood and almost never discussed. Equities can compound in value in a way that investments in other asset classes, such as bonds and real estate, cannot. The reason for this is quite simple: companies retain a portion of the profits they generate to reinvest in the business.

If you look at companies in the major indices, such as the S&P 500 or the FTSE 100, you will find that on average companies pay out about half of their earnings in dividends. The earnings that are not paid out are invested in the business. No other asset class provides this.

If you own bonds, you receive an interest payment but it is not automatically reinvested in the bonds. The only exception to this is so-called payment-in-kind bonds issued by highly leveraged companies, which provide the option for them to issue more bonds if they are unable to pay the cash coupon. So you get more bonds but only at a moment when the last thing you want is for your interest payment to be invested in more of this junk. Similarly, if you own real estate, you will receive rental income but none of it will be reinvested in property for you.