Investors buy stocks for potential price appreciation (e.g., capital gains) and dividends. It helps to have a basic understanding of stocks to increase your investment successes, says Pat Swanson, CFP® and families specialist with Iowa State University (ISU) Extension’s Invest Wisely Project (www.extension.iastate.edu/investwisely).
There are several ways to categorize stocks. Income stocks are those of companies that regularly pay a high percentage of their earnings in dividends. Blue chip stocks are large industry-leading companies. They tend to be of low or moderate risk with consistently increasing dividends. “These are the types of stocks that you can hold and have less concern for ups and downs in the market,” Swanson says.
Growth stocks are shares of companies that have shown relatively fast growth in earnings, which cause their price to rise. Typically growth companies are in new or fast-growing industries. They make no or small dividend payments because the company puts its earnings back into the company for future growth. “Growth stocks are considered riskier; individuals who invest here are willing to accept more volatility in hopes of making large capital gains over the long run,” Swanson adds.
A stock whose price does not reflect its earnings is considered to be a value stock. Value stocks have relatively low prices compared to their historical earnings and the value of the company’s assets. A company that has had a temporary setback but is fundamentally sound may be another kind of value stock.
Cyclical stocks tend to rise and fall with the economy. For example, stocks of companies in the travel industry are cyclical because individuals and companies cut back on travel when the economy slows. On the other hand, defensive stocks such as utility stocks are not affected significantly by changes in the economy.
Speculative stocks are those of start-up companies or companies that have lost much of their value and may or may not recover. Penny stocks refer to low-priced (below $5) speculative stocks of very small companies. “There is much volatility with these stocks,” Swanson says. “Although there are some winners, most speculative stocks do not do well.”
Swanson says if you are investing for an investment goal many years in the future, you may not want to receive cash dividends. Instead, you may want to reinvest any dividends to purchase additional shares. “Companies that have dividend reinvestment plans, also known as DRIPS, allow you to automatically reinvest any dividends to purchase additional shares as well as to buy more shares with extra cash you want to invest. A DRIP is an easy and less expensive way to purchase additional shares of stock.”
However, Swanson suggests that if you don’t have the skill or time to select and monitor individual stocks or sufficient wealth to adequately diversify through purchase of many different companies, you may want to consider mutual funds that pool money from many investors to purchase a basket of stocks. A fund’s objective may be growth, income, a combination of the two or many other objectives.
Index funds include stocks that compose a benchmark index such as the Standard and Poor’s (S&P) 500. “Over the past three years the S&P 500 has outperformed more than 65 percent of mutual funds invested in large company stocks. Historically the return of the S&P 500 has been around 10 to 11 percent,” Swanson concludes.
The ISU Extension Invest Wisely Project provides a series of newspaper, radio, and web resources for investors. It is funded by a grant from the Investor Protection Trust (IPT). The IPT is a nonprofit organization devoted to investor education. Since 1993 the IPT has worked with the States to provide the independent, objective investor education needed by all Americans to make informed investment decisions. www.investorprotection.org.