When building an investment portfolio with stocks, investors should aim to find a mix of different types of stocks. To choose the right stocks, you’ll need to consider what types suit your risk tolerance, your short-term needs, and your long-term personal financial goals.
And this all begins with understanding different types of stocks.
In this article, you’ll learn why it’s important to understand different types of stocks, a brief overview of stocks and how they generate value for investment portfolios, and the various ways stocks can be classified and — more importantly — evaluated.
Why Understanding Different Types of Stocks Is Important
Investors sometimes think there are only two types of stocks: the kind you buy and hold forever and the kind that day traders gamble with. This couldn’t be further from the truth.
To invest wisely, to achieve proper diversification, and to maximize the likelihood that your investment will grow over time, it’s important to understand the different way stocks are categorized and the right way to allocate those different categories within your own portfolio.
Although every stock can experience volatility and the share price can potentially decrease in value, once you get a handle of the different types of shares, you can more easily mitigate the risk of being too heavily invested in any one type of stock.
How to Think About Stocks
First, to think about these types of stocks more easily, let’s begin with a review of the definition of what a stock actually is.
What Is a Stock?
A stock represents a percentage of ownership in a publicly traded company. When you buy stock, you now essentially own small pieces of the company in the form of your shares.
When you have stock, you have ownership, or equity, in that company. That’s why you’ll hear stocks sometimes referred to as equities.
How Stocks Generate Value
Investors earn money in the stock market in a few ways. Let’s look at two of the most common.
First, the market price of the stock can increase over time. This type of value generation is called capital appreciation.
Then, certain companies will issue dividend payouts periodically to the people that own the company’s stock. Creating this type of value is called income generation.
The Different Types of Stocks
Now onto the different types of stocks and the way analysts and market experts will discuss them.
Stocks can be grouped in a number of ways. In this article, we’ll examine five of the most common classifications: by how the stocks generate value, by investment strategy, by risk, by industry, and by company size.
Value Generation Category: Growth Stocks vs. Income Stocks
Growth stocks and income stocks generate value in different ways and are therefore best suited for different types of investors.
Maybe you’ve seen mutual funds that advise younger individuals to be heavily weighted toward growth stocks, and as you approach retirement, the mutual fund shifts its allocation more toward income stocks. Same idea here.
When considering growth vs. income stocks, the investment advice will typically depend on how far you are from retirement.
Growth investing, just like it sounds, is a method where the investor seeks out companies poised for long-term growth. Growth stocks will have more potential for greater return, but this of course comes with a higher level of risk.
Growth stocks are typically for younger investors who have time until retirement to wait for the stock price to appreciate in value.
The name might have tipped you off, but these stocks generate steady, predictable, and stable income in the form of dividends. Income stocks are popular with those looking for passive income and with retirees.
Income stocks are typically associated with less risk and volatility. But, you know the saying “no pain, no gain”? That’s going to apply here. Because you have less risk (pain), you’re going to see less gain in the stock price of income stocks.
Utility companies are a popular type of income stock. Other large and stable income stock companies can be found in the energy, real estate, and natural resources sectors.
Investment Strategy Category: Growth Stocks vs. Value Stocks
Another way stocks can be compared is according to the investor approach. In other words, what are investors looking for?
In this section, you’re going to see the growth stocks we just discussed compared to a new type of stock: value stocks. But this time, growth stocks are being compared according to investor approach.
Investors seeking stocks with a strong outlook for a company’s profits will gravitate toward growth stocks.
But, again just like it sounds, value stocks are those that have a good deal of value at a certain point in time.
These companies are typically well-known in their industries and on the more mature side. For whatever reason their stock price might seem undervalued — in relation to their own average stock price or the stock price of their competitors — at any given moment, making them a value stock.
In other words, value investors seek companies with market pricing that feels like “a good deal.” Imagine your mother sifting through the racks at Marshalls looking for that great dress at an unbelievable price. That’s your value stock.
Risk Tolerance Category: Blue-Chip Stocks vs. Penny Stocks
Again, more pain (or risk) equals more gain. So in these two types of stocks, we’re looking at risk and reward.
Investors with more money to risk or more time to make up any potential losses can take more chances and shoot for those higher returns. Investors who are on the more conservative side will be just fine with lower returns as long as they know their investment is on the safer side.
Blue-chip stocks are investments in companies that are financially stable and typically quite large with market capitalizations in the billions. Often an industry leader, the company is established and has been around for many years.
Typically listed on the Dow Jones Industrial Average index, the stock price of a blue-chip stock doesn’t have much room to grow. Investors will usually profit, however, from dividend payments.
Penny stocks, as the name implies, can be purchased for pennies.
These companies have shown very little — or even zero — earnings and are very volatile. However, they may be getting a lot of attention because of new products, expansion in the right market at the right time, or even due to shake ups of management or the board of directors that promise a brighter future.
These stocks come with a good deal of risk (potential pain) and therefore offer the chance at significant returns — and lots of gain.
Market Capitalization Category: Micro-Cap, Small-Cap, Mid-Cap, and Large-Cap Stocks
Different market caps are calculated by multiplying the company’s stock price by the total number of outstanding shares.
Generally large-cap companies tend to be more established and will have more international exposure. On the other end of the spectrum, micro-cap companies tend to be newer, riskier, offer more growth potential, and more focused on the domestic market.
Typically, the categories breakdown as follows:
- Micro-cap: $50 million to $300 million
- Small-cap: $300 million to $2 billion
- Mid-cap: $2 billion to $10 billion
- Large-cap: $10 billion to $200 billion
Volatility Category: Cyclical Stocks vs. Defensive Stocks
Every economy tends to experience periods of cyclical expansion and contraction. During times of prosperity, business booms. During times of economic recession, business suffers. Cyclical stocks ride the tide with this cyclical movement. And defensive stocks won’t even step foot on the beach — never mind get near the water.
Any public company that provides luxury items will ebb and flow with economic upswings and downturns.
For example, travel is a luxury, so the travel industry is a cyclical stock.
Remember when companies in the travel industry were crushed by COVID-19? Once the pandemic is behind us, every person and their brother will want to travel. At that point, stocks in the cyclical travel industry will likely be poised to explode.
Cyclical stocks operate like growth stocks — higher risk in exchange for the potential for higher rewards.
In stark contrast, defensive stocks strive to be non-cyclical stocks. These stocks won’t typically see those significant swings between prosperity and recession.
Why, you ask? Because defensive stocks are backed up by companies that offer essential products and services. Grocery store chains and utility companies are examples of companies that provide these kinds of necessities. During times of hardship, people will continue to need food, water, and electricity.
Defensive stocks are going to operate more like income stocks — paying dividends and offering lower returns in exchange for that lower risk.
Which Different Types of Stocks Are Right for Your Retirement Portfolio?
Investing in stocks is one of the most important pathways to financial success. And diversification is important for developing a strong investment portfolio. A strategic combination of different stock types will help achieve that kind of diversity. Striking the right combination is where the magic happens.
You’re taking the right steps by educating yourself in order to make good investment choices. To learn more about stocks that could provide a strong foundation for your retirement portfolio, subscribe to Investors Alley’s “Dividend Hunter” newsletter.