The Types of Stocks You Should Know About Before Investing

John Mlekoday is a senior investment consultant with the Northwestern Mutual Wealth Management Company.

For many investors, stocks can help generate wealth over the long term. That happens when share prices increase or if the company pays dividends. That’s why you’ll find them in most investment strategies—from the well-known 60/40 portfolio (with 60 percent stocks and 40 percent bonds) to funds aimed toward a retirement date. But all stocks aren’t created equal. There are many different categories of stocks with different attributes.
 
Below, you’ll get a closer look at the main categories of stocks. You’ll learn about the factors you can consider to help you understand which types of stock do—and don’t—belong in your portfolio.

How stocks are categorized

Stocks can be categorized in lots of different ways, such as company size to the sector it operates in. And stocks fall into multiple categories. For example, a growth stock can also be a stock with a relatively small market size (Small Cap) and a socially responsible choice. A value stock can also be a Small-Cap stock and a dividend stock.

Small-, Mid- and Large-Cap stocks

Because companies of different sizes often have similar growth and risk profiles, stocks can also be categorized by the market capitalization (shortened to “market cap”), which is basically the value of the underlying company:

• Small-Cap stocks: Companies with a market cap between $300 million and $2 billion
• Mid-Cap stocks: Companies with a market cap between $2 billion and $10 billion
• Large-Cap stocks: Companies with a market cap of at least $10 billion
   

Small-Cap stocks often offer investors a greater potential for returns but have increased volatility and downside risk. Large-Cap stocks, on the other hand, tend to offer a bit more stability—but with less potential for growth. Mid-cap stocks, as you might expect, fall somewhere in the middle.

You might also hear about Micro-Cap or Nano-Cap stocks, which are even smaller than Small-Cap stocks. At the other end are Mega-Cap stocks, which have a market cap of at least $200 billion.

Value stocks and growth stocks

Two more stock categorizations are value stocks and growth stocks. Value stocks are stocks that appear cheap compared to the financial performance or fundamental value of the company. Investors buy value stocks in the belief that the market will eventually recognize this mismatch, resulting in a higher price per share. Value stocks tend to be larger, more established companies that often pay dividends.

Growth stocks, on the other hand, are those that investors believe have the potential to experience significant growth. Investors buy growth stocks because they believe that the share price will increase as the company executes its strategy and realizes this growth. While they are often smaller companies, larger companies can also be considered growth stocks. Because growth stocks typically reinvest profits in the company, they typically do not pay a dividend. They also often have a high price-to-earnings ratio, which can make them appear more expensive compared to the broader market.

Blue chip stocks and penny stocks

Blue chip stocks are sometimes considered “the best of the best.” These well-established companies have a track record of high performance. They tend to be a stabilizing force in an investment mix—typically in exchange for lower rates of growth compared to less well-established stocks.

At the other end of the spectrum, penny stocks are often associated with low-quality businesses and small market caps. These stocks are typically valued between $1 and $5 per share. Some investors are drawn to penny stocks because they offer the ability to build a position in a company before it “hits it big”—which can be incredibly lucrative. The downside is that penny stocks carry significant risk, including a very real risk that the underlying company might go bankrupt, resulting in the complete loss of your capital. Likewise, because penny stocks often have low share volumes, it can be more difficult to liquidate your investments into cash compared to the stocks of more established companies.

Cyclical stocks and non-cyclical stocks

The performance of cyclical stocks is closely tied to the broader economic cycle. When the economy is expanding and consumers have plenty of cash, cyclical stocks tend to perform well. But when the economy is contracting and consumers are spending less, they tend to perform poorly. Stocks related to consumer discretionary spending are an example of cyclical stocks, because they’re often the first thing to get cut out of consumers’ budgets vs. necessary spending.

Non-cyclical stocks, on the other hand, aren’t as linked to the broader economic cycle. That’s because non-cyclical stocks tend to be tied to things that people always need, regardless of how the economy is doing. Companies related to consumer staples (like food), energy, utilities and health care are examples of non-cyclical stocks. Because they are less susceptible to economic downturns, they are also sometimes called defensive stocks.

Dividend stocks

Investors looking to generate an income from their holdings without needing to sell their assets often gravitate toward dividend stocks. These are stocks that return profits to shareholders in the form of a periodic cash payment or in the form of additional stock. Although many dividend stocks pay dividends on a quarterly basis, there are companies that pay dividends monthly and biannually as well.

Dividend investors use a variety of metrics to evaluate a company before making an investment, including:

• Dividends per share, which is the actual dollar amount the company has most recently paid per share of stock. It helps investors anticipate how much income they might generate from their investments.
• Dividend payout ratio, which is the percentage of a company’s income that is paid out as dividends and which helps investors understand how “safe” the dividend might be.
• Dividend yield, which compares a stock’s share price against its annual dividend payout and which helps investors analyze the financial health of a company.
   

While dividend stocks can be a great way of generating passive income from your portfolio, dividend payments are not guaranteed. If a company encounters financial hardship, it can reduce or even eliminate its dividend completely. When this happens, it often has the added negative effect of tanking the stock’s share price.

Sector stocks

While we tend to discuss “the market” as though it’s one thing, it’s actually composed of 11 different sectors, or industries.

The performance of companies in each of these sectors can vary a lot. Their value can depend on economic trends (like inflation, interest rates and unemployment numbers). Other considerations that might affect one (or a few) sectors but not the entire market include industry-specific regulations, global political situations or supply chain issues.

Many investors will diversify across all sectors to avoid being overly exposed to the risks of one industry. Others may prioritize one or a handful of sectors that they believe are primed to outperform the broader market.

ESG stocks

Environmental, social and corporate governance (ESG) is an investing philosophy that considers how well a company adheres to various standards. So ESG stocks are investments in companies that have demonstrated a commitment to high ESG standards. There are no specific benchmarks that companies must hit to be considered an ESG investment. The company usually has taken steps to lessen its negative effects on the environment and society while also operating transparently and fairly with its shareholders.

ESG stocks offer the potential for profit while investing in companies that align with your moral priorities. On the flip side, this investment philosophy avoids companies that don’t match your values. While it can be a good filter to apply to an investment opportunity, focusing solely on companies that align to your values is unlikely to give you enough information to build a well-diversified portfolio.

Other things to know about stocks before you invest

Knowing what categories a stock falls into can give you a number of quick insights into investing in it. But a stock’s “type” can’t tell you everything. Here are some other factors you might want to consider.

Common stock risks

In general, stocks are one of the riskier asset classes that investors can invest in—especially compared to cash equivalents (like certificates of deposit) and bonds. But that doesn’t mean you shouldn’t include stocks in your portfolio. In fact, the increased riskiness of stocks is why they carry a greater potential for return compared with low-risk investments.

Still, it’s worth being aware of the different investing risks that stocks can be subject to so that you can make sure you’re not taking on too much of any one type of risk as you build your portfolio. These include:

• Market risk: The risk that the price of your stocks will fluctuate with the market.
• Interest rate risk: The risk that changing interest rates might affect the value of your investments.
• Inflation risk: The risk that your investment’s return will not match (or ideally exceed) the rate of inflation.
• Liquidity risk: The risk that you will not be able to convert your stock into cash if you need to do so. This is more of a concern with alternative investments or Small-cap stocks with low trading volumes than with larger, more popular stocks.
• Systemic risk: The risk that the overall market will be negatively affected by a variety of economic factors, ranging from interest rates and inflation to unemployment and more.
• Nonsystemic risks: Risks associated with a single company or industry rather than the whole market.

Performance of stocks over time

Over the long term, Large-Cap stocks have seen exceptional growth, averaging approximately 10 percent growth per year since 1957. But past performance doesn’t guarantee future results. Nor does long-term growth mean that the stock market never sees any losses.

In fact, since 1957, the stock market has also seen periods of extraordinary volatility and contraction. This includes 11 bear markets when the market declined by at least 20 percent.

Common stock and preferred stock

Some companies offer two classes of stock—common stock and preferred stock. While both represent partial ownership of a company, there are important differences to know.

When you buy common stock, you’re entitled to a share of the company’s profits, whether in the form of dividend payments or price appreciation in the form of share buybacks, etc. Your shares also give you voting rights over certain corporate activities, which can shape the direction of the company moving forward.

When you buy preferred stock, you’re entitled to a share of the company’s profits. But you’re also buying preferential treatment over common shareholders. Preferred shareholders receive dividends before common shareholders, typically at a fixed rate that is higher than the dividend for common shareholders. Preferred shareholders also get priority over common shareholders if the company goes bankrupt and is liquidated. One trade-off: Preferred shares do not carry voting rights.

Most investors purchase common stock with the goal that the shares will appreciate significantly in value over time. While preferred shares can also appreciate, they tend to be less volatile than common shares, making them better suited for investors seeking stable income.

Choosing types of stocks to invest in

In the end, while a diversified portfolio will help you manage risk, there is no single best way to invest that’s guaranteed to work for everyone.

Ultimately, the types of stocks you invest in should depend on your risk tolerance, investment timeline and financial goals. Your Northwestern Mutual financial advisor can help you tie these all together. The two of you can design a portfolio that matches your goals and coordinate your market-based investments with a broader financial plan that includes additional assets.

No investment strategy can guarantee a profit or protect against loss. All investing carries some risk, including loss of principal invested. Past performance is no guarantee of future performance.