In order to assist investors in their journey to select the stocks that best match their risk tolerance, asset allocation and overall investment objective and strategy, stocks can be classified and identified according to certain common characteristics.
The most common stock classifications are by market capitalization, by type, by location or by ownership. Before buying shares make sure you are familiar with the characteristics of each stock classification in order to help manage the overall risk of your portfolio through the selection of a well-balanced and diversified asset allocation.
Stock classifications by Market Capitalization
The stock classification by market capitalization (also known as market cap) identifies companies according to their total market dollar value which is equal to the number of outstanding shares multiplied by the current share price. The three main market cap categories are large cap, medium cap and small cap. Some analysts provide a further segmentation of the classifications but the three above are the most widely used. A company is considered to be a large cap if it is valued over $10 billion. A medium cap is between $2B and $10B, while a small cap is valued at less than $2B. Although the prices of all stocks are volatile by nature, small caps tend to exhibit greater volatility because they are associated with higher risk.
Stock classifications by Type
A stock can be classified as a growth stock, value stock or as an income stock. Growth stocks are growing rapidly but they usually do not pay any dividends (or pay very low dividends) to the shareholders as they reinvest earnings to fuel the growth. In some cases growth stocks may not generate any profits at all yet, since the future growth expectations of stocks influence their price, growth stocks tend to be expensive so be sure you have done your homework and have an adequate margin of safety when buying a growth stock.
Value stocks are tend to have less risk and lower volatility than growth stocks. These are stocks that are trading at a price below what the stock appears to be worth according to its fundamentals. Investors looking for value stocks are on the search for good bargains, trying to buy a relatively good stock that they feel is temporarily out of favor in the marketplace and trades at a good discount to its intrinsic value. For example, there might be a financially sound company that is trading at a big discount due to the negative perception investors have of the current CEO. Higher dividend payments are usually associated with value stocks compared to growth stocks. While growth stocks usually have higher Price to Earnings (P/E) ratios, value stocks are associated with lower P/E ratios.
Companies that share profits with shareholders through higher dividend payouts are known as income stocks. Electric utility company stocks are examples of income stocks. They tend to have lower risk and volatility than growth stocks. Retirees tend to favor income stocks which provide them with a relatively stable source of income.
Stock classifications by location
An investor can further diversify their portfolio by investing in both domestic and foreign stocks. Domestic stocks are issued by US-based companies and are traded on the various stock exchanges such as the NASDAQ and the New York Stock Exchange. Foreign stocks are issued by non US based companies. The stock of foreign companies can also trade on the US stock exchanges through what is known as an ADR (American Depositary Receipt). Foreign stocks can be further segmented based on whether the country where they are located is classified as a developed country such as Japan or Germany or an emerging market country such as China or India. Emerging market stocks tend to exhibit higher volatility and risk compared to developed market stocks.
Stock classifications by ownership
There are two classifications of stocks based on ownership: common stock and preferred stock. The vast majority of shares being traded on the stock market are common stocks. Just as the name suggests, they are “common”. Common stock represents ownership in a company and as an investor in common stock you also have a claim on the profits generated by the company (through dividend payments). As a common stock shareholder you also have the right to vote to elect the board members. Compared to preferred stock, common stock holds a higher degree of risk. This is due to the fact that if the company were to go bankrupt, the common stock shareholders would be the last to be paid, if anything were left, after the creditors, bond holders and preferred stock shareholders get paid. Investing in common stock can provide high returns, but make sure to diversify your asset-allocation and look for common stock of companies with strong fundamentals.
Shareholders of preferred stock own a certain degree of ownership in the company but do not have the same voting rights of common stock shareholders. They receive guaranteed fixed dividend payments, whereas common stock shareholders dividend payments fluctuate with the bottom-line (profit) of the company. Because of such advantage, preferred stock share price does not fluctuate as much as the share price of common stock. Think of preferred stock as an investment channel between a bond and common-stock. By investing in preferred stock you enjoy the fixed income but miss-out on the potential capital gains which attracts so many investors to the common stock.