For most individuals, the most popular investment vehicles are stocks and bonds, as well as real estate for certain investors. Just as there are several different types of real estate, there are different categorizations of both bonds and stocks. Investors, even amateur ones, should understand the key differences between these different types of investments and what those differences mean for risk and return potential. Bonds are rather clearly delineated and rated, but understanding how stocks are classified can be more difficult. The typical ways of classifying stocks include:
Many people classify stocks based on how the company plans to grow and its policy for distributing dividends. For example, the term blue-chip stock refers to companies with strong histories of profits and dividend payments. These stocks are the safest to invest in because the companies are large and stable. However, stock prices for these types of companies tend to be very steady, so the potential for returns is actually fairly limited. Smaller companies with a lot of room for growth tend to yield better returns.
Investors may hear the phrase income stock. In general, income stocks are for companies that are stable and pay large dividends. These investments can be good for individuals who are retired or approaching retirement, since they provide a steady income stream without much risk. When dividends are added to stock price appreciation, they can often be better investments than bonds and other forms of fixed-income investment. However, stock values could fall in a market downturn, which is not the case with bonds.
The phrase growth stock points to a company with profits that are increasing very quickly and driving the stock price. Companies in this category tend to reinvest profits from stock sales and pay little or no dividends to stock owners, who are expected to get income from the growth in stock price.
Value stocks are for companies with a low price-to-earning, price-to-dividend, or price-to-sales-and-cash-flow ratio. These ratios mean that the stocks are undervalued when compared to similar companies. Undervalued stock could relate to company distress or simply cyclical trends. In the last century, value stocks have had a tendency to perform better than growth stocks, but they are significantly more risky.
Another common way of classifying stocks refers to ownership rights and privileges. Most stocks fall in the common stock category. A common stock provides a piece of company ownership and entitles the holder to a claim on a certain percentage of company profits, paid out as dividends. Common stock holders also have the power to elect board members who oversee management decisions. In the history of investment, common stocks have provided the highest returns, but they also have the highest risk, since common shareholders only get paid after preferred shareholders, bondholders, and creditors if a company goes bankrupt. Individuals can temper the risk of common stock through diversification.
Common stock is further divided into three different gradations. Class A common stock is that which can be sold, bought, and held by individuals. Typically, these stocks have one vote per share. Class B stock is held by company insiders and not traded on the public market. In general, these stock holders have more voter rights than Class A stock holders. Class C stocks are publicly traded, but they have no voting rights.
Preferred stock is the counterpart to common stock. Individuals who hold preferred stock do not have the same voting rights as those who hold common stock. However, preferred stocks usually come with the guarantee of a fixed dividend. Common stock dividends fluctuate depending on company performance. While preferred stocks offer more reliable income, the prices do not appreciate as much as with common stocks. On the other hand, preferred stocks also depreciate less when the market experiences a downturn. In addition, preferred stockholders are paid off first in the event of bankruptcy.
Many investors use size to categorize stocks. Market capitalization is a quick and easy way of comparing companies horizontally. Individuals can calculate market capitalization by multiplying the number of outstanding stocks by the current price, which offers a quick valuation of the company. Based on market capitalization, companies can be described as anything from nano-cap, a market capitalization below $50 million; to mega-cap, a company with a market capitalization over $200 billion. No exact cutoffs exist for these labels, but they are helpful when comparing companies across industries.
Size categorization plays an important role in mutual funds, as many will invest only in small-, mid-, or large-cap companies. It’s important to remember that there’s a clear correlation between risk, return, and size. Smaller companies are riskier because they have fewer resources to deal with economic downturns, but they also have the most potential for growth and can offer incredible returns. Small-cap companies tend to produce higher returns than mid- or large-cap companies. Many investors will “tilt” their portfolios toward smaller companies to tap into this greater chance for growth, but some larger companies can offer a portfolio stability in the event of a market downturn.