With a size that exceeds $80 trillion in value, the stock market is crucial to the global economy and capitalism. Stocks are among the most traded financial instruments and represent fractional ownership in publicly listed companies and corporations.
They are bought and sold at major exchanges like the NYSE, the LSE, and Nasdaq but individual investors normally rely on the services of online or landbased brokers who deal with the exchanges on their behalf.
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Investing in the stock market is no picnic and is associated with a significant amount of risk. Nonetheless, this form of investment is broadly considered one of the most effective ways to boost one’s net worth, which is why affluent businessmen normally have most of their money invested in stocks.
To successfully trade on this market, one must adopt a disciplined approach and get acquainted with the different types of stocks. What type you choose should be based on your interests, the amount of money you have available to invest, your risk tolerance, and investment goals.
Not surprisingly, common stocks are the most widespread type of stocks bought and sold by investors. They date as far back as the early 17th century when the Dutch East India Company launched them on the stock exchange in Amsterdam.
Quite simply, common stocks are shares of a company that provide the buyer with certain rights that often include voting on a company’s affairs. Those who hold common stocks normally have a say when it comes to voting on corporate policies like whether or not a company should accept an acquisition offer. They can also participate in electing the company’s Board of Directors.
Holding common stocks enables investors to have a partial ownership in a given company but without the necessity of taking actual possession. Some common stocks also pay a dividend that rewards investors for buying and holding the stock.
One of the biggest advantages of common stocks is that they tend to produce greater return rates over time. The high-risk level associated with these stocks is compensated for by their higher profit potential in the long run. However, unpredictability and increased volatility render them unsuitable for short-term investors.
One of the biggest disadvantages of common stocks begins to manifest itself whenever a company or corporation decides to put an end to its business. In case of liquidation or bankruptcy, the holders of this stock type are the last ones to get paid. The company would first distribute disbursements among creditors, preferred shareholders, and bondholders before common stockholders receive their shares. This peculiarity further increases the level of risk associated with common stocks.
Taking a Closer Look at Common Stocks
Here are some important things to understand about common stock shares. Each stock share is equal to every other stock share in its class. This way, ownership rights are standardized, and the main difference between two stockholders is how many shares each person owns.
The only time a business must return stockholders’ capital to them is when the majority of stockholders vote to liquidate the business (in part or in total). Other than this, the business’ managers don’t have to worry about losing the stockholders’ capital.
A stockholder can sell his or her shares at any time, without the approval of the other stockholders. However, the stockholders of a privately owned business may agree to certain restrictions on this right when they first became stockholders in the business.
Stockholders can put themselves in key management positions, or they may delegate the task of selecting top managers and officers to the board of directors. This a small group of persons selected by stockholders to set the business policies and represent stockholders’ interests.
The all-stocks-are-created-equal aspect of corporations is a practical and simple way to divide ownership but its inflexibility can be a hurdle, too. Suppose the stockholders want to delegate to one individual extraordinary power, or to give one person a share of profit out of proportion to his or her stock ownership. The business can make special compensation arrangements for key executives and ask a lawyer for advice on the best way to implement the stockholders’ intentions.
Nevertheless, state corporation laws require that certain voting matters be settled by a majority vote of stockholders. If enough of them oppose a certain arrangement, the other stockholders may have to buy them out to gain a controlling interest in the business. The limited liability company legal structure permits more flexibility in these matters.
When you mix stocks and bonds, you get a preferred stock. Similarly to common stock, the value of a preferred stock rises and falls. However, preferred stocks also act like bonds in that they pay a fixed amount to the shareholder in the form of a dividend.
While common stocks and preferred stocks are the two most widespread groups, stocks can also be classified according to the type of company that issues them. One key difference that distinguishes preferred from common stocks is that the former do not grant the holder a say when it comes to the company’s policies.
Preferred stockholders lack any voting rights when the time arrives for a business to appoint a new Board of Directors, for example. With that in mind, preferred stocks can offer several advantages to investors, starting with the fact they normally guarantee a fixed dividend for the holder.
By contrast, common shares typically have fluctuating dividend value. Preferred stockholders can calculate the value of the dividend if they divide its dollar amount by the shares’ price. This type of stock has a par value that is influenced by interest rates.
While the value of common shares is determined by supply and demand on the market, that of preferred stocks fluctuates proportionally to the rise and decline of interest rates. It drops whenever they increase.
The rights of preferred shareholders are greater than those of common shareholders but lesser than those of bondholders. Thus, if a given company finds itself in dire straits from a financial perspective, it is obligated to pay dividends to its preferred stockholders prior to paying the common shareholders. Nonetheless, preferred shareholders are inferior to creditors and bondholders.
Another downside of preferred stocks is their smaller potential to increase in value. There is a few dollars difference between the prices they trade at and those they were initially issued at. Some preferred shares can also be converted which means the investor has the option to exchange them for common stocks when specific conditions are met.
Whether or not this conversion works to the investors’ benefit depends on the current market prices of the common shares. Preferred stocks can be bought by individual investors via brokers or by whole institutions who purchase them in large bulks.
This is usually done for the purposes of raising great amounts of capital within short periods. However, the reasons are sometimes regulatory, particularly when regulations prevent the institution from acquiring any more debt. This type of stock is associated with lower trading volumes which makes it more difficult to purchase or sell.
Sometimes stocks are categorized based on their market capitalization, which is the total value of all the shares of a company. Market cap is important because it gives investors an idea about one company’s size in relation to another. Calculating market capitalization is beyond simple – all you have to do is multiply the overall number of outstanding stocks a given company has issued by the current price-per-share.
So, if a company has 1 million shares that trade at a value of $10, the market capitalization of that company would equal $10 million. Investors normally use the market cap to assess the size of companies and corporations but it is also important when determining the value of acquisitions. The higher the market capitalization, the greater the takeover’s value for the acquiring side. A rule of thumb for companies that are categorized by their market cap would be:
– Mega-cap: Over $200 Billion
– Large-cap: Over $10 Billion
– Mid-cap: $2 Billion to $10 Billion
– Small-cap: $250 Million to $2 Billion
– Micro-cap: Below $250 Million
– Nano-cap: Below $50 Million
Market capitalization matters because it also influences the choice of investment strategy. Long-term traders are better off investing in the stocks of large-cap or mega-cap companies like Microsoft or Facebook, for example, since these bring in greater returns over time. It is typical for them to demonstrate consistent growth in terms of stock value over the long haul.
Companies that belong to the mid-range of market capitalization are already established but still face further growth in the future. Cabot Microelectronics, Peloton Interactive, and Mercury General are all examples that belong to this category. They are normally associated with higher levels of risk compared to large-cap corporations but still attract stock investors with their potential for expansion.
Businesses that belong to the small-cap spectrum, like Bed Bath & Beyond, are relatively young and have yet to cement their positions in their respective industries. However, companies that have lost their value in recent years can also be included in this category.
Small-cap businesses come with higher capital appreciation but this is at the expense of higher levels of risk. Their stock has a smaller number of publicly traded shares which leads to reduced liquidity. In turn, this means it might take more time for investors to purchase or sell holdings with small daily trading volumes.
Micro-cap and nano-cap stocks are deemed suitable for traders who insist on portfolio diversification and have a high tolerance of risk. Researching such companies is significantly more time-consuming simply because less information is published for them.
Such stocks have small liquidity due to the absence of institutional purchases and analytical coverage. Their high volatility stems from the fact such companies are associated with a greater risk of failing. These businesses are not as strictly regulated as the biggest publicly traded companies, which means investors face a greater risk of becoming victims of pump-and-dump schemes.
Class A and Class B Shares
A distinction can also be made between Class A and Class B common stocks. Class A shares are simply a special classification giving the shareholders extra or different voting rights. For example, Class A shareholders may have 10 votes for every share they own, not simply the one per share of a Class B shareholder. Generally speaking, most investors will only be able to purchase one class of shares.
Class A shares traditionally are unavailable for sale to the general public. They are intended for a company’s senior managers, important executives, and board of directors. This classification is necessary because it prevents alien investors from purchasing enough shares to assume total control over the company.
Shares from this class give holders more advantages including greater voting privileges and liquidation preferences. There are several sub-groups of shares from this category like traditional and technology Class A shares. High-priced shares are another sub-category. Outside investors technically have access to them since they are publicly traded but cannot buy them due to their high cost.
Class B comprises a category of common stocks associated with lesser voting privileges compared to Class B shares. They are also accompanied by lesser priority when it comes to the payment of dividends. The whole purpose of this classification is to ensure a company’s key executives and managers are endowed with more control to prevent hostile attempts at takeovers on outsiders’ behalf.
Stocks by Economy Sector
Quite often, you will see stocks classified based on their sector. The stock market can be divided into eleven major sectors as follows:
● industrials (eg. Uber Technologies)
● basic materials (BHP Billiton)
● energy (BP, Chevron)
● consumer staples like food, beverages, and tobacco (Pepsi Co.)
● consumer discretionary (Amazon, Nike)
● healthcare (Johnson & Johnson)
● financials (Goldman Sachs)
● information technologies (Netflix, Nvidia, Microsoft, Facebook)
● telecommunication services (Vodafone, Verizon)
● utilities (Duke Energy)
● real estate (Simon Property Group)
The goal of this classification is primarily to assist stock investors in viewing different assets in a more organized way. There could be considerable differences in the performance levels of the different stock sectors.
Some thrive during economic downturns while others perform better whenever the underlying economy flourishes. Investors should research the sectors carefully to get acquainted with their characteristics. This would enable them to better assess the value of the stocks they purchase.
Cyclical and Non-Cyclical Stocks
Also known as defensive stocks, non-cyclical stocks are those of companies that belong to essential industries like the ones from the consumer staples sector. The products of such businesses will sell well even during economic slumps. For example, the population will continue buying soap, beverages, and food no matter the current state of the economy. Utilities like electricity and water also belong here.
Because of this, non-cyclical stocks perform very well during economic downturns. And vice versa, when the economy is in particularly good shape, their prices tend to take a plunge. The name “defensive” stocks is no misnomer. Investors use them as defense mechanisms to generate steady profits during slumps of the economy.
The opposite is true for cyclical stocks – they perform better when the economy is thriving. This is because both businesses and regular consumers tend to have greater purchasing power during economic upturns.
One prime example of cyclical stocks comes from the automotive industry. A healthy and prosperous economy means higher employment rates. In turn, this leads to more car sales. Respectively, periods of uncertainty result in high levels of unemployment due to massive worker layoffs.
It only makes sense that people hold onto their money in this case and are averse to the idea of making unessential purchases. Of course, the same is valid for businesses as well. When times are difficult, companies will naturally invest less into expansion and equipment, which, in turn, will cause the value of their shares to plummet.
Classic examples of cyclical (or offensive) stocks come from the sectors of technologies and real estate. Experienced investors often combine both types as a means of portfolio diversification. This enables them to weather out tough economic periods. Non-cyclical stocks will appreciate in value to compensate for the price slumps observed with cyclical stocks.
Growth and Value Stocks
Stocks can also be grouped into categories based on value and growth. Growth stocks are those with high potential to outmatch the overall market’s performance in the future. The concept is borrowed from fundamental analysis. This type of stock is offered by companies with large, small, and medium market capitalization.
Such businesses have decent chances for significant future expansion, either due to adequate management or because their products are expected to be in high demand in the future. Once a company reaches its full potential, its shares will lose their “growth” status.
By contrast, value stocks are inherent to mega-cap companies that have already attained a well-established position in their respective sectors. The shares of such businesses usually trade at lower prices than those analysts deem fitting for their actual worth.
The reasons for this undervaluation can be different including the perception of the general public, unethical practices on behalf of the company, or the involvement of key figures in public controversies. Value stocks are associated with lower volatility and are therefore recommended to risk-averse investors. Traders with higher risk tolerance often turn to growth stocks.
Stock derivatives are types of investments that derive their value from underlying assets such as a stock. The most popular are stock options, which provide you with the chance to buy or sell a stock at a certain price before an agreed-upon date. So, if you believe a stock is going to go up in value, you may buy a call option at today’s price, promising the seller that you will buy it by a predetermined date for a predetermined price. Options trading is considered very risky by many.
When no one is buying a stock because of a high price, companies will often issue a stock split. When this happens, a company gives you more stock for your money. They simply distribute more stocks, and decrease the prices. This just allows someone who doesn’t have as much money to invest in a company.
If you own stocks in a company that splits two for one, you would get twice the amount of stocks that you had before, but each stock will have decreased in value by fifty percent. Stocks can split into any number, but they can also reverse split. This means the stocks double in value, but you only get to keep half the stocks you had before. In either split, you do not lose any money. It is just like exchanging two five-dollar bills for one ten-dollar bill, or vice versa.