Generally, stocks are divided among various categories. At the top are the stocks issued by large, well-established companies, often called blue chip or large-capitalization (large cap) stocks. Stocks issued by smaller companies are often divided by their size or market capitalization into mid-cap and small-cap stocks. Growth stocks are those with the potential to grow quickly in both revenues and profitability, but perhaps without the proven track record more established companies have. Some may be large and even market-leading companies in their industries, but with plans to dramatically expand their businesses. Value stocks are those that analysts feel are selling for less than the company is really worth.
Stocks can also be divided into domestic stocks (those issued by U.S. companies) and international stocks. You can also divide your money among various sectors of the market, such as technology, communication, healthcare, energy, financial services, consumer goods and basic materials, each of which may respond differently to economic changes.
RISK VS. RETURN FOR STOCKS
Over the short term, investing in the stock market can pose quite a risk. After all, the market’s history includes such events as the Crash of 1929 and the Depression that followed, the bear market of 1972 through 1974,the tumble of October 1987, and most recently the stock market crash on September 29, 2008 when the Dow Jones Industrial Average fell 777.68 points in a day. That wasn’t the end of the volatility when, again, on March 5, 2009 the market feel more than 50% from its pre-recession high less than 18 months previously.
Individual stocks face risks as well. A company, because of poor business conditions or poor management, could become unable to make dividend payments. Or it could fail, leaving your stock worthless. The stock market can also be volatile, fluctuating because of events happening overseas, rumors of economic changes, or a key investment advisor’s pronouncement that the market, some segment of it or a particular stock is overvalued.
Over the long term, however, stocks have earned higher and more positive returns than any other financial investment. These higher returns help offset the risks of investing in stocks.
Stocks can yield two types of return: capital return and income return. Capital return is when the market price of your investment — a share of stock — increases or decreases from your original purchase price. Income return is the payments — dividends — a company makes to its shareholders each year. Together, these make up your stock’s total return.
DIVERSIFICATION CAN MINIMIZE INVESTMENT RISK
Among the risks you face in the stock market is the risk that you will have to sell an investment for less than you paid for it. If you buy stock in many different companies, in many different sectors of the market, you can minimize your risk. After all, it is highly unlikely that every company in which you have invested will suffer at the same time.
You can also minimize your risk by investing some money in international stocks. Historically, when the U.S. stock market has dropped, markets in Europe and Asia have dropped less, or even risen in value. Although we live in an increasingly global economy where economic events have an impact everywhere, global diversification should still be a part of your plan.
WHAT ROLE SHOULD STOCKS PLAY IN YOUR PORTFOLIO?
In general, money you won’t need for at least 10 years should be invested primarily in stocks. Certainly younger people investing for their retirement should consider putting a substantial portion of their funds in stocks.
Investing in stocks may also be appropriate for retirees who don’t need all of their money and are trying to maximize what they will pass onto their heirs. Your best bet is to work with a financial advisor to determine the optimal amount you should allocate to stocks.