Contents
Stock Investing Basics
Types of Stock
Stock Indices
How to Determine Your Level of Risk Tolerance
How to Plan Your Stock Portfolio
How to Research Stocks
How to Buy and Sell Stocks
How to Manage Your Stock Portfolio
Stock Investing and Taxes
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Types of Stock
Many companies offer two different types of stock to the public: common stock and preferred stock.
- Common stock: The more popular of the two types of stock, common stock accounts for most of a company’s daily stock volume (the number of shares exchanged each trading day). Shares of common stock are generally much more volatile than those of preferred stock and often don’t pay dividends. Owners of common stock have voting rights, which can give them a say in major company decisions, such as electing the board of directors.
- Preferred stock: Preferred stock offers a fixed stream of dividend payments. Preferred stock shareholders lack voting rights but get first priority over common stock shareholders in dividend and other payments, such as payments after bankruptcy.
The vast majority of stock investors invest in common stock. So from here on, any time this guide mentions “stock,” it will be referring exclusively to common stock.
Classifications of Common Stock
Investors use a number of different methods to classify and group stocks to help them assess which stocks best suit their stock portfolio—the collection of stocks that an investor owns and manages (see How to Plan Your Stock Portfolio). Investors often categorize stocks by:
- Growth-vs.-value classification
- Company size (or market cap)
- Industry group (or sector)
- Geographic location (domestic vs. international)
Growth Stocks vs. Value Stocks
Investors divide stocks with strong price-appreciation prospects into two categories: growth stocks and value stocks.
- Growth stocks: Growth companies tend to be newer, rapidly expanding companies whose sales growth and earnings growth are expected to outpace that of the market as a whole. Though share prices of growth stocks may rise more quickly than share prices of value stocks, growth stocks are considered riskier than value stocks because they tend to be priced at a premium to the overall market and rarely pay dividends.
- Value stocks: Value investors look for companies whose stock appears to be undervalued relative to underlying fundamentals (key company statistics such as sales, earnings, dividend yield, and so on). Value stocks often are older companies that pay dividends and tend to be less risky and volatile than growth stocks, though they also tend to offer less opportunity for large returns. Value investors must be careful to avoid value traps—stocks that appear to be undervalued but actually are suffering from serious problems in their company or industry, which have in turn depressed their stock price.
Value stocks and growth stocks offer different benefits depending on your financial goals. Investors near retirement tend to prefer the safety and reliable income of value stocks, whereas investors who can tolerate more risk and have a longer timeframe tend to favor growth stocks.
Company Size (Market Cap)
A company’s market capitalization, or market cap, is the total value of a company’s publicly traded stock. Market cap equals the number of publicly available shares multiplied by the current share price. For example, a company with 10 million shares outstanding and a share price of $10 has a market cap of $100 million. A company’s market cap fluctuates as its share price moves up or down.
The Five Market Cap Categories
Stocks can be placed into five basic groups based on the size of their market cap. (Note that the market cap ranges included in these descriptions may vary over time.)
- Mega-cap stocks: Giant companies with market caps over $200 billion, such as General Electric and Microsoft. Mega-caps, along with some large-caps, are also known as blue-chip stocks.
- Large-cap stocks: Companies with market caps of $10–200 billion. Large-cap stocks are typically well-known household names, such as Apple.
- Mid-cap stocks: Companies with market caps of $2–10 billion. Examples of mid-cap companies include Hilton Hotels and Urban Outfitters.
- Small-cap stocks: Companies with market caps of $100 million–$2 billion. Many small-cap stocks are of companies whose names you probably wouldn’t know.
- Micro-cap stocks: Companies with market caps under $100 million. These stocks often trade on markets other than the Nasdaq or NYSE. These markets, known as the OTCBB (over-the-counter bulletin board) or pink sheets, are less rigorously regulated by the SEC than the more popular exchanges, which makes buying these stocks very risky.
To provide a more precise description of a company, investors often combine the growth-value classification with market cap, resulting in descriptions of stocks as “large-cap growth,“ “small-cap value,” and so on.
Market Cap and Risk
In general, larger-cap stocks are safer investments:
- Smaller-cap stocks tend to be more risky but often have higher prospects for growth and significant share price increases.
- Larger-cap stocks tend to be less risky but usually offer less chance of huge growth and returns.
Although these rules generally hold, they’re not always true. For example, Google was already a large-cap company when it went public in 2004, yet its stock price still rose tremendously over the following year. On the other hand, the pharmaceutical mega-cap Merck plunged more than $100 billion in value over the period from 2000–2005.
Industry/Sector
Stocks can also be classified by industry, or sector—the general type of business in which the company is involved. For example, major industry/sector groups include technology, healthcare, utilities, financial, consumer goods, industrial goods, and so on. Stocks within a given industry or sector often share certain predictable traits, such as how quickly they grow and whether they pay dividends. For a more extensive list of industries, see the Industry Center on Yahoo! Finance at http://biz.yahoo.com/ic/ind_index.html.
Domestic Stocks vs. International Stocks
U.S.–based investors have the opportunity to include both domestic (U.S.–based) and international (foreign-based) companies in their portfolio. International stocks can help to diversify a portfolio. However, they also carry risks related to foreign exchange rates and political stability.
Some foreign economies, such as those of western Europe, Australia, and Japan, are well-established, developed economies. Others, such as Brazil, Russia, India, and China, though growing rapidly, are much less stable—either politically or economically or both. These less stable countries are termed emerging markets.
Emerging Markets
Emerging market stocks have the potential for growth rates and returns that far exceed those typical of more developed economies. For example, Brazil’s stock market index tripled from 2003–2005, while the U.S. market barely budged.
However, emerging markets are highly speculative and risky. Currency exchange rates may fluctuate wildly, which can have a significant impact (either positive or negative) on the stock prices of companies in emerging markets. Given the extreme volatility of stocks in emerging markets, only investors with a high risk tolerance and long time horizon should consider buying these stocks (see How to Determine Your Level of Risk Tolerance).
Other Types of Common Stock
Some stocks—whether domestic or international—have unique traits that require categories of their own.
- Real estate investment trusts (REITs): REITs are companies that specialize in real estate or other property-based investments, such as timber, that generate income. REITs are required to distribute at least 90% of their taxable income to shareholders through dividends, which gives REIT investors the benefit of high dividend payments. Some REITs behave like growth stocks, which means REITs offer the rare and alluring combination of growth and income.
- Master limited partnerships (MLPs): MLPs are companies in which investors are direct partners in the business but do not share the liabilities involved in owning and running the business. MLPs are not subject to income tax and therefore distribute much of their income in the form of dividends, some of which can be as high as 10–15% annually. MLPs tend to be concentrated in the financial services, real estate, and natural resources sectors.
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