Understanding the types of stocks and how they fit with your investing strategy will make you a more successful investor
Getting started investing in stocks can be more than a little scary. Stocks can be confusing and complicated. Entire professions are spent understanding how to pick the right investments.
Fortunately, it doesn’t have to be complicated. The very fact that investing can be easy is the reason I created this website. To help you understand the basics of the stock market and how anyone can manage their own money to reach their financial goals.
That starts with understanding the types of stocks, first the main types of investments and then the different types you need in your portfolio.
Let’s start with an official definition of types of equity investments and then I’ll show you how to use the different types of stocks in your strategy.
What are the Three Main Types of Stocks?
There are three main types of stocks from a technical standpoint. The difference here is in what you get as an investor, your rights and the opportunity for return.
Common stocks are ownership of the company’s cash flow and assets but with no preferential rights. This is what most people think of in stock investing and what you see quoted in the markets.Preferred shares are a special type of stock that holds preferential rights to payments but may not have the upside ownership of common stocks. Most preferred shares are convertible into common stock at a certain rate of preferred-to-common.Share classes can include different types of common stock which have different levels of voting rights and protection. When this happens, it’s usually to protect the voting rights and control of a family that once owned the company.
The truth is most investors will never deal in anything other than common stocks and knowing about these other two types of stocks won’t matter to your investing strategy. Instead of dwelling these technical definitions, let’s look at another way to look at stocks that really matters.
Other Types of Stock Classification
There are other ways to separate stocks that mean more to your investing strategy and how you reach your goals. This will classify stocks into other groups according to investor strategy, type of business and even company size.
Stock Types by Investing Strategy
The most common way to classify types of stocks is by an investment strategy like growth, value or dividend investing.
Growth stocks are typically companies with higher rates of sales and earnings growth. These stocks are generally more expensive on an earnings-per-share (EPS) basis because investors expect growth to continue and the share price to surge.
Value stocks are companies that may not be growing as fast but still have solid fundamentals and a competitive edge. Because of this lower growth or some other factor, the share price might be cheaper on an EPS basis. Value investors argue that they are getting a bargain for shares of a company with more stable and reasonable long-term growth.
Dividend stocks are companies that return a regular cash payment to investors, usually four times a year. This can mean any stock with a dividend payment but more often means stocks with a yield above the market average. Dividend investors like getting paid to invest in a company while they wait for the share price to increase.
The reason we separate stocks this way is so we can pick stocks that will more closely meet our return needs and investing style. Some investors want a steady dividend yield from their stocks and believe that reinvesting these dividends will result in the highest total return. Other investors want a good deal on the stock price, paying less for the earnings per share.
Types of Stocks by Sectors and Business
The way I most often look at stocks is by sector and industry. Within the overall economy, there are 11 sectors of companies that fulfill a certain need or business activity. Within each sector are industries that create a similar product or service.
For example, the consumer staples sector produces things people generally can’t live without and buy on a consistent basis. Within the consumer staples sector are industries like food manufacturers, household products, beverages and tobacco.
The Select Sector SPDR funds are a group of exchange traded funds (ETFs) that hold shares in the sectors.
The reason you might want to separate stocks by sector is that sectors react differently to changes in the economy.
Utilities, Communication Services and Staples tend to be less volatile and do not fall as much in a recession. Interest rates may affect these sectors because the high dividend yield in the group.Other sectors like health care and technology may benefit from broad forces like an aging demographic or technological progress.Financials will depend heavily on interest rates and government regulations.
There are a lot of ways to invest by sector, rebalancing your portfolio according to the economy or making a bet on the strength in a particular sector. While it is nearly impossible to pick individual stocks for market-beating returns, you can follow the economic cycle and adjust your portfolio for the sectors that tend to do the best.
Besides by sector, you can also separate stocks by where they have their headquarters. Stocks are classified as either foreign or domestic depending on where you live and where the company was incorporated.
Investors tend to have too much of their portfolio in companies domiciled in their own country. That leaves them at greater risk when a recession leads to a recession. Not only might they see their wealth evaporate but their job could be at risk as well.
That means you might want to consider actively investing in companies based outside of your home country. This can help diversify your investment wealth from the rest of your finances.
Types of Stocks by Company Size
One last way stocks are often classified is by the size of the company, the market capitalization. Market cap is the total value of the shares or the number of shares times the stock price.
Micro-cap Stocks are companies under $300 millionSmall-cap Stocks are companies from $300 million to $3 billionMedium-cap Stocks are companies from $3 billion to $15 billionLarge-cap Stocks are companies from $15 billion to $100 billionMega-cap Stocks are companies with a market cap above $100 billion
It always seemed funny that a ‘small cap’ company would be one valued at up to $3 billion but that just gives you an idea of the massive size of companies in the stock market.
The reason stocks are sometimes classified by size is because of that idea in risk and return. Smaller companies tend to be riskier because they don’t have that massive scale enjoyed by $100 billion companies but they might also have greater flexibility to respond to customer needs.
For this reason, small cap stocks tend to outperform when the economy is strong and they’re able to take advantage of all their opportunities. Conversely, small cap stocks underperform when the economy is struggling and only the large, financially-healthy companies are surviving.
Within each of the types of stocks above, understand that a company can be classified in different ways. A single stock might be a growth stock, in the tech sector and a large cap stock.
You don’t necessarily need to follow each type of stocks when you decide which stocks to buy. Understanding the different classifications will help understand how each might help you invest better or more appropriately. Look over each category and think about how it relates to your investing needs and strategy.
Read the Entire Investing in Stocks Series
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