So far in this series we have covered the different terminology used in investing, dispelled some common investing myths, different types of investments, how to approach the sharemarket, how to reduce our exposure to risk, and what impact our own behaviours have on our investments. If you are new here, I suggest starting here.
Now we can discuss the different types of stocks available to invest in.
So, you’ve analysed your risk levels and what you are comfortable with and decided you would lie to invest in stocks. Just like potato chips in a supermarket though, there are many varieties of stock. Let’s explain the main ones:
CHOOSING BY STYLE
1/. Growth stocks
These are companies that are focused on growing their business. When they make profit, they tend to re-invest the money back into the business. This means low or no dividends to the investor. As an investor in growth stocks you are relying on the potential for capital gains, so it can be risky. Many technology companies fit this profile.
2/. Value stocks
Companies that are undervalued by the market. It could be for reasons such as bad publicity, a disappointing earnings report and so on. Value stocks are riskier than growth stocks because of the sceptical attitude the market has towards the stock. If you are picking value stocks you are basically saying that you know better than the majority. On the flipside though, there is potential for greater returns.
3/. High dividend stocks
You can also invest in a group of stocks that pay high dividends. Dividends are generally paid twice a year and can be re-invested or received as income. Dividends are a percentage of company earnings paid to you per share you own in the company. The regular payments are attractive to many investors, especially those approaching retirement. If you are looking at this option, just because a company is paying high dividends now, they may not be forever. It is essential to look at the history of the company paying dividends. Although history is not a guarantee of future dividends, it does give a good indication of the likelihood. Especially if the company has a habit of increasing dividends every year.
Dividend paying companies are often well established, stable companies, with good cash flow. Their stock prices tend to be less volatile. Less likely to go down in price as much, but also less likely to increase in price as much. Just because a company is paying high dividends, does not make it an automatic choice. You still must make sure that the basic business fundamentals are there such as good market share, profits and so on.
CHOOSING BY SIZE
1/. Small cap stocks
'Cap' stands for capitalisation, which means how much of the market the company has. It is calculated by multiplying the share price by the number of shares. Small cap is typically companies with capitalisation of less than $1 billion. Small cap companies offer investors more room for growth, but are also riskier and more volatile than large cap companies as are more likely to fail. They are more unlikely to pay large dividends due to low cash flow liquidity.
2/. Large cap stocks
Capitalisation of $5 billion or more. This can differ by markets. For example, the US is a much bigger market with larger companies, so the distinction for large cap there is $10 billion or more. Large cap companies are traditionally stable with good dividend flows. Less potential for growth though.
3/. Mid cap stocks
Companies with capitalisation of between $1 billion and $5 billion. Historically, these companies offer more stability than small cap stocks, but offer more growth potential than large cap stocks.Conversely, less stability than large cap and less growth potential than small cap. They are as they say - medium risk, medium reward.
CHOOSING BY GEOGRAPHY
With the internet, we can invest in almost any country in the world. By investing in other countries outside our own, we are increasing our diversification. Spreading our risk because we don’t expose ourselves to the fortunes of just one market in one country. Some countries have markets that are more developed than others so keep an eye out for this. Developed countries markets are more advanced economically with high levels of liquidity, income per capita, regulation and capitalisation. New Zealand, Australia, and the United States can all be included here.
Emerging markets are much riskier and more volatile than developed markets due to their smaller size, lower income per capita, and fewer regulations. Markets such as Brazil and South Africa. The growth potential is also higher but you must ask yourself if the risk is worth it? The answer will be dependent on your tolerance for risk, your goals and your investing timeframe.
When investing internationally, currency risk is also introduced. Not only are you relying on good returns from the companies invested in, you are also relying on a favourable currency exchange rate.
CHOOSING BY INDUSTRY
Companies in similar industries can be grouped together into one sector. These industries are:
- Financials: Such as banks and insurance companies
- Utilities: Such as electricity and water
- Consumer discretionary: Such as restaurants, jewellers and clothing retailers
- Consumer staples: Such as food and beverage
- Healthcare: Such as medical equipment, hospital management and biotechnology companies
- Energy: Such as oil and gas exploration
- Technology: Such as information technology, software developers and electronic manufacturers
- Industrials: Such as machinery, construction and agricultural equipment
- Materials: Such as farming, forestry, mining and crop growing.
- Telecommunication: Phone, cable TV and internet.
We can diversify our investments by industry since they often have different characteristics and are not co-related. For example, consumer staples are relatively safe investments because people have to eat and drink. These are good investments to have during recessions because they are a must have for people. Even when times are hard we have to eat. Whereas, consumer discretionary spending is usually the first thing to go when in difficult financial times. In good times though, discretionary spending goes well.
Some industries are much riskier than others. But with more risk, usually comes higher potential for growth.
I NOW KNOW THE DIFFERENT TYPES OF STOCKS I CAN BUY, SO HOW DO I DECIDE?
With any investing you should first determine your goals and your tolerance for risk. Once both have been determined, you are in a strong position to decide what type of investments best suit your goals and risk levels. If you have a goal to invest for 7 years and your risk tolerance is low, then value stocks in South Africa may be a bad idea. The riskier an investment is, the longer the timeframe you should allow for investing.
If your goal is to retire in 5 years then it may be a good idea to slowly reduce your risk exposure and invest in dividend paying stocks. Everyone has unique goals and unique lives that require unique, personal analysis.
You also don’t necessarily have to decide between value or growth, small or large cap, NZ or China, financials or healthcare. This is not an either/or decision. You are well entitled to buy a bit of everything if your goal is a well-diversified, lower risk portfolio. This can easily be achieved with very little money with index investing.
If you are still stuck on what to invest in, then it may be advisable to seek assistance from a paid professional investment adviser. Yes, it will cost money up front, but if it means getting you across the line to start investing it should be worth it. A good adviser will return more than the cost of the adviser. Make sure to do your research on advisers if you take this path.
These first 7 articles are informing us with the basic information we need to decide what type of investments we want to make up our portfolio. Our next step is to look at what proportion of our money to invest on each type of investment. In part 8 of the series we will look at how to construct our portfolio.
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here
We welcome your comments below.