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The stock market consistently delivers one of the best overall returns on investments and stock investment should play an important part in your overall financial management. Although it might seem complex and complicated for many people, the stock market is not as difficult to understand as you might think.
What Is A Stock
A stock represents a proportional ownership interest in a company, in other words, a small part of the value of a company. When you decide to buy a stock in a company, you are buying a small portion of that company. The interest in this transaction is two-folded:
- The company is searching for a convenient method to raise money to develop its business, to hire more employees, expand its activity etc
- You, as a buyer, become a shareholder in the company, and you are (hopefully) sharing the success of the company
Now, why do you buy stocks in a company? To make money, of course. The stock market is all about making money. It’s simple, you buy a stock in a company that has good financial results, with good future perspectives and that makes a profit. You make money when you buy the stock at one price, and selling it at a higher price.
Types Of Stocks Based On Ownership Rights
There are two main types of stocks: common stock and preferred stock. Below are the main characteristics of each type.
Common Stock
- The majority of stock is issued is in this form
- Represents the basic ownership of part of a company and a claim on a part of the net profit recorded by the company
- An owner of common stock is entitled to one vote, two shares equal two votes and so on. So, the more shares an investor owns, the stronger the vote
- An owner of common stock can also vote during elections in company’s Board of Directors
- On the long-term, the common stock offers higher returns compared to other investments
- Common stock has a significant risk: if the company goes bankrupts, the common shareholders are the last in line. They will not get paid until the creditors, bondholders and preferred shareholders recoup a part of their money
Preferred Stock
- The main difference between a preferred stock and common stock is that preferred stock investors are usually guaranteed a fixed dividend payment
- If the company goes bankrupts, preferred shareholders recoup a part of their money before the owners of common stock get paid
- Preferred stock may be callable, meaning that the company has the option to buy back the shares of preferred owners, usually for a premium
- Companies don’t issue preferred stock until after the common stock was issued
- Preferred stock owners don’t generally get proxy rights
Types Of Stocks Based Company Focus
The companies have particular goals that define their stocks. One stock may be focused to offer investors higher dividends, while another may attempt to obtain capital gains. Other stock may focus on raising quick money for the company. Thus, in order to maximize the stock’s ability to meet their objectives, companies will treat their stocks accordingly.
Blue-Chip Stocks
- Blue-chip stocks are stocks in well-established and financially secure.
- Blue-chip stocks have a large market capitalization, of billions of USD, and are among the market leaders in their sector.
- Their long-term success is almost guaranteed, being the most stable and solid stocks on the market.
- Blue-chip profits are based on investors buying the stock and holding it for a large period of time.
- Most blue chips are paying investors stable or increasing dividends.
- As the return of blue-chip stocks is almost guaranteed, the stocks tend to be expensive and to have a low dividend yield.
- Stocks of this type include companies such as IBM, Coca-Cola, AT&T, Intel, Disney etc
Secondary Stocks
- Stocks of this type include well-established companies, but not in the blue-chip league yet.
- These companies have a smaller market capitalization than blue-chips, generally below the 1 billion USD level.
- Secondary stocks tend to be a little more volatile than blue chip stocks, as their price fluctuates more, so they come with a higher risk.
- Secondary stocks have the potential of bringing investors significant gains with relatively small investments, due to their increased volatility.
- The probability that these companies will go out of business is low.
Income Stocks
- Income stocks are stocks in companies that are fairly well-established and that record profit regularly.
- Include shares of companies that give money back to investors in the form of dividends
- When the company registers a profit, its reinvestment will usually come in a smaller proportion, as providing dividends is more important.
- Usually, older investors who are near retirement are attracted to income stocks because of their dividends allocation.
- Income stocks are less volatile, meaning that this type of stocks don’t increase or decrease as quickly as other stocks, which is why they are preferred by conservative investors.
- An important advantage of stocks that pay dividends is that the dividends reduce investors’ losses if the stock price records a downtrend.
- Stocks of this type include companies such as AT&T, Philip Morris International, Verizon Communications Inc., General Mills, ExxonMobil, Procter & Gamble, Pfizer etc
Growth Stocks
- Growth stocks are stocks that are being valued on their potential, rather than actual intrinsic value.
- Investors usually bet that these companies will grow faster than the competition, usually as a result of a great product/service or due to their capable management.
- Growth stocks typically reinvest all the profits they make for increasing the business. This means that investors buy growth stocks because they anticipate the value of the stock to increase as opposed to buying the stock for receiving a dividend.
- Most of the time, growth stocks won’t pay dividends.
- Investors in growth stock usually plan to make their profits by selling the stock at considerably higher prices.
- The price of growth stocks can be high despite the fact the company’s result aren’t spectacular.
- Growth stocks are extremely volatile; they can make huge price moves in either direction.
Value Stocks
- Value stocks are stocks of profitable companies that are trading at a reasonable price compared with their true worth, or intrinsic value.
- A value stock is considered undervalued compared to its fundamentals, meaning that its price should be higher compared to the current market price.
- Value stocks are often those of mature companies, such as insurance companies and banks.
- Investors who are interested in value stocks analyze carefully the companies by using a number of fundamental tools (P/E ratios, Price-to-Book ratio etc.) in order to find these bargain stocks.
- Value stocks are likely to increase in price in the future, but not as quickly as other stocks.
- Value stocks are considered riskier than growth stocks but could offer investors a higher long-term return.
Penny Stocks
- Penny stocks are stocks that are usually traded for less than a dollar per share (some people define a penny stock as one selling for less than 5 USD per share).
- Penny stocks don’t meet the minimum requirements for listing on a major stock exchange, so they trade on the over-the-counter market (OTC).
- These stocks offer investors their potential. Penny stock investors are buying the stock at very low prices hoping for a home-run.
- Penny stocks are cheap for a reason: no earnings, high debt, poor management etc
- The trading volume on penny stocks is very low. With such low-volume, it’s easy for dodgy investors to manipulate the price.
- Penny stock prices are extremely volatile.
Types Of Stocks Based On Market Capitalization
Market capitalization is a reflection of the size of a company. The market capitalization of a company is calculated by multiplying the number of outstanding shares by the current stock price. For example, if a company had 10 million shares of common stock and a current stock price of 1 USD per share, its market cap would be 10 million USD (10 million x 1 USD).
There are three categories of stocks when we take into account the market cap.
Large Cap Stocks
- Large-cap companies have the least risk because they typically have a financial stability
- The market capitalization for these companies exceeds $10 billion.
- Large-cap stocks are considered market leaders in their sector.
- Large-cap stocks are the most stable and solid stocks on the market.
- The return of these stocks is not as high as small or mid-cap stocks
- Large-cap stocks are paying investors stable or increasing dividends.
- The stocks tend to be expensive and to have a low dividend yield.
Mid Cap Stocks
- Include companies with a capitalization between the values of 2 billion USD to 10 billion USD.
- Mid-cap stocks are expected to increase their profits and market share.
- Mid-cap stocks are less risky than small-cap stocks, but riskier than large-cap stocks.
Small Cap Stocks
- Small-cap stocks have a market capitalization of less than 2 billion.
- They are smaller companies, with lots of room to grow.
- Small cap stocks are riskier, but could offer investors a higher long-term return.
- Small cap stocks are extremely volatile; they can make huge price moves in either direction
Final Thoughts
Stock market could be a fun game, but before entering the ‘playground’ you must be sure you know what you’re up against before you invest your first dollar. First of all, as an investor, you must determine what are your goals and expectations when buying a stock and what types of stocks you prefer trading with.
Are you focused on stocks with high rates of return? Then you should track the evolution of growth stocks or value stocks.
You prefer safer and conservative stocks? Blue-chips and income stocks are your alternatives.
It’s up to you to discover the level of your risk tolerance and the types of stocks you prefer to hold in your portfolio.
