You might be wondering why you should invest in various types of stocks when you could just put your money in bonds or keep it in cash. One of the main reasons to invest in stocks is that you can earn more from them than from other investments. Stocks have historically had an 11% compound total return, vastly outperforming government bonds (5%) and real estate investments (4%).
When it comes to stock investments, you need to be aware of different types of stocks. By understanding the types of stocks, you’ll be in a better position to make informed investing decisions.
What is the stock market?
First, let’s define stocks. Stocks are a small piece of ownership in a company. When you purchase stock, you buy a portion of the company and become a shareholder. As a stockholder, you have the right to vote on corporate matters and receive dividend payments.
On the other hand, the stock market is where stocks are traded between investors. It’s important to note that the stock market is not a physical place. Instead, the stock market is a system of stock exchanges where traders and investors can buy and sell publicly traded companies.
The stock market is an integral part of the economy because it allows companies to raise money by selling shares to investors and allows investors to make money based on the company’s profits. When a company’s stock price goes up, stock owners make money, and when it goes down due to an economic downturn, investors lose money.
Advantages of owning stocks
Owning stocks is advantageous because it has the potential to generate high returns. Over the years, stocks have generated average returns of around 10% per year, though this has varied a lot with some years having significant gains and others having significant losses.
Stocks are also a good inflation hedge because high consumer spending and economic growth can cause inflation, and these factors lead to companies earning more money. Even during times of inflation many companies can make a profit.
Stocks are also a good diversification tool, as they can help you gain higher returns than other types of lower-risk investments. Stocks tend to increase and decrease in value differently than other investments such as bonds and cash.
8 types of stocks
There are different types of stocks that you can choose from. Your portfolio will depend on you as an investor and what market cap you prefer investing in, such as small-cap (companies with market capitalizations of $300 million to $2 billion), mid-cap stocks ($2 to 10 billion), or large-cap stocks (over $10 billion). It will also depend on the benefits and features of the stock categories, which are discussed below.
1. Common stocks
One of the main types of stock is the common stock. It represents ownership in a company, where you buy a small portion of the company and become one of the common shareholders.
As one of the common stockholders, you have the right to vote along with the company founders and to receive common stock dividend payments.
2. Preferred stocks
Preferred stock gives preferred stockholders priority over common shareholders when it comes to receiving dividends and owning assets in the event of liquidation. However, preferred shareholders do not have voting rights.
Many companies that issue preferred stock also offer common stock. However, preferred stocks are typically offered in much smaller quantities than common stock.
3. Blue-chip stocks
Blue-chip stocks are large corporations with a strong reputation that are usually well-established and financially successful businesses and have been in operation for a long time. Most blue-chip stock belongs to the large-cap stock category.
This stock type is considered “defensive stocks,” which help to protect a portfolio through consistent performance and dividends regardless of the overall economy’s performance. This means that they are non-cyclical stocks and perform relatively steadily. Examples are Coca-Cola, IBM, and Johnson & Johnson.
4. Growth stocks
Growth stocks have a significantly greater growth rate than the market average. These stock prices increase faster than the market’s average stock, resulting in more earnings.
Generally, growth stocks can be identified by their high price-to-earnings (P/E) ratio, which you can calculate by dividing the market value per share by the current annual earnings per share. Examples of growth stocks are Google, Amazon, and Facebook.
5. Income stocks
Income stocks, often known as dividend stocks, represent equity stocks that pay dividends regularly and steadily to their shareholders. Low volatility, regular dividend distribution over the last 10 to 15 years, steady dividend increases, and a record of increasing earnings growth are the most common characteristics of an income stock company. Examples of income stocks are utility, telecom, and consumer staples companies.
Penny stocks
A penny stock is a stock that trades for less than $5 a share. This usually belongs to smaller companies with lower market capitalization than small-cap stocks (sometimes called micro-cap stocks) and are generally listed on smaller exchange-traded funds (ETFs).
Although some penny stocks are traded on major exchanges like the New York Stock Exchange (NYSE), most are traded over-the-counter through the electronic OTC Bulletin Board or OTC Markets Group. Penny stocks can be a risky investment because if the company fails or runs into financial troubles, you might see the share prices drop or completely lose market value. On the other hand, they are very inexpensive.
Value stocks
A value stock is a stock that tends to trade at a lower price than its assets, such as dividends, earnings, or sales, making it attractive to value investors. Value stocks are usually found in well-established companies with a history of paying dividends.
Examples of value stocks are Bank of America, Citi Group, Inc., and Wells Fargo. International stocks also tend to be value stocks and provide additional geographic diversification to your portfolio.
Cyclical stocks
Cyclical stocks are companies whose sales and profits rise and fall with the economy. A cyclical stock company’s earnings do well when the economy is doing well.
But when we are experiencing an economic slowdown, their sales and profits will usually decline. Examples of cyclical stocks are automobile companies, steel companies, and airlines.
Frequently Asked Questions
Understanding the different types of stocks is essential because each type has unique characteristics and knowing the differences can help you make more informed investment decisions. Below are some FAQs that will help you further understand the types of stocks.
What is the difference between common and preferred stock?
The clear difference between preferred and common stock is that preferred stock does not provide shareholders voting rights, but the common stock does. Preferred shareholders receive dividend payouts before common shareholders because they have priority over a company’s income.
What type of investor would income stocks be good for?
Income stocks tend to be less volatile and offer stability, which is why they would suit conservative investors. Other investors, such as growth investors, may shy away from income stocks because they offer little potential for capital appreciation.
What are the key features of growth stocks?
Growth stocks are stocks of companies that are growing at a faster rate than the overall market. They tend to be more volatile than other stocks but offer the potential for higher returns. Growth stocks are typically found in industries experiencing rapid growth, such as technology and healthcare.
Where can I buy blue-chip stocks?
Blue-chip stocks are stocks of large, well-established companies that are leaders in their industries. They are typically found on major exchanges such as the NYSE or Nasdaq.
The bottom line
With careful research and an understanding of your risk tolerance, you can find solid opportunities in stocks. In fact, stocks provide the best long-term growth (capital gains) opportunities for investors. Investors willing to hold stocks for a long time have typically seen high, positive returns.
Remember, no investment is ever without risk. It is essential that new investors consider consulting with investment professionals for investment advice to create a diversified portfolio that meets their unique needs. Stock ownership is one of the simplest and most effective ways to build long-term wealth and stability for you and your family.
