We should buy stocks that fit our investment strategy; however, finding the right ones can be tricky since there are over 6,000 companies listed on US exchanges alone.
Understanding the different types of stocks available will help us narrow down which ones will be suitable for our needs. One way is to look at how big the company is based on its value. The stocks in each group will have similar risk and return characteristics.
We sort company's by their value as a way to use general trends about the potential growth and risks. There are many ways to value a company, each with its own set of advantages and drawbacks.
The most commonly used measure is market capitalization (or market cap) because it's an easy starting point for a company's size.
In general, companies with larger market caps tend to be less risky since smaller ones often have more challenges to overcome. However, these larger companies also tend to have lower potential growth and returns.
These companies are the most established and valuable.
The products and services they provide are understood well globally. They also have the people and money to minimize operating risks, making them the most stable.
The Nasdaq 100 and S&P 500 are major indexes that include the top large-cap companies.
Generally, these companies are up-and-coming, growing to become the large-cap stocks of tomorrow. However, they could also be yesterday's large-cap stock, losing value because of an underperforming business.
They have proven their business model significantly and have de-risked enough for investors to put more faith and value behind these businesses. However, there is still significant room to grow. Mid-caps provide us with medium risk and medium returns.
Major indexes like the S&P 400 and Russell Midcap Index include the top mid-cap companies.
These companies have more growth potential than mid and large-cap stocks. However, they are still evolving and face substantial uncertainty, opening us up to greater risks of losing money.
Not all small-cap stocks are newer companies, driving innovation. This group also includes older companies that have fallen from grace, replaced by new technology. As a result, these companies can have minimal growth potential. We should be cautious about the stocks we buy in this category.
The Russell 2000 index and the S&P 600 are popular indexes that track the top small-cap companies.
These stocks are the riskiest among the four groups. These businesses are often niche and may have a hard time raising money for expenses or growth.
Like small-cap companies, most of us overlook these businesses because they face tremendous risk and are considered very speculative investments.
Some micro-cap stocks aren't listed on the major exchanges, known as penny stocks or pink sheet stocks. We should avoid these stocks. They are not often required to report the progress of the business at the scrutiny regulators set forth to protect investors and can have fraudulent practices.
Base your investment decisions on many factors. One of the first and easiest to use is market cap because of the simple risk-return trends.
Get familiar with these descriptions. They're a great starting point for identifying which stocks are appropriate for your portfolio and fit your needs.
For example, consider large-cap stocks if you're looking for stocks that are relatively less risky. On the other hand, mid and small-cap stocks usually have more return potential if you have a higher risk tolerance.