Types of stocks, pros and cons
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If you want to invest in stocks, you need to know what kind of stocks you want. Each type of stock behaves fundamentally differently and it's important to know why and if you should include them in your portfolio. Some examples:
- Growth stocks
- Value stocks
- Dividend stocks
- Defensive stocks
You'll find more information about creating a investing portfolio in chapter 39. For now, let's have a look at the different type of stocks you can buy.
4.1 Growth stocks
Growth stocks are stocks from companies that have the goal to grow. These stocks typically trade above average market prices. For investors this means making money through capital gains (rise in stock price). That also means investors only make money when they sell the stock as growth stocks often do not pay any dividends.
While dividends are a way to please and attract investors, growth stocks are all about growing the company. Instead of paying dividends, the company uses this money to grow the business. In order to grow above the average company in the market, the company needs unique products or services. That means more money needs to go to research and development. For example, Amazon reinvested almost every profit it made for several years. Allowing them to grow very fast.
Growth stocks can be highly volatile. Meaning, the stock price can vary wildly in relative short periods of time. But if the market switches the attention on the “next big thing” prices can drop and can stay low for many years.
|Can have huge gains||No dividend payment|
|Faster growth||High volatility|
Overall, growth stocks tend to have a high price to earnings ratio and are trading for premium prices. Don't worry, you'll learn more about ratios and premium in other chapters. Examples of growth stocks are:
4.2 Value stocks
Value stocks are the opposite of growth stocks. Value stocks are stocks trading below their intrinsic value. You can find value stocks by determining their intrinsic value and compare this to the current stock price. If the price is trading below the intrinsic value, the stock has potential for the future and could be considered as a great value. Remember that the stock market is just what it is, a market. Companies can always be under or overvalued because people (investors) are overlooking things.
Value investing is one of the most popular ways to invest and is the foundation Warren Buffet used his entire career. In simple words, value investing is finding stocks that are undervalued. Once found, they are typically held for many years or decades.
|Undervalued stocks (low risk, high reward)||Can take a long time to see profits|
|Hard to find in today's market|
4.3 Dividend stocks
Dividend stocks are picked for their dividend payments. This gives the investor a steady amount of extra income. Solely focusing on dividend stocks can generate a high and steady amount of income but also has its pitfalls. High dividend yield sounds good but it can destroy capital gains. Dividend yield is the expected profit based on the current stock price and amount of annual dividend. When the stock price drops, dividend yield rises. This may be actually a bad thing. I'll discuss dividend yield and its potential problems more in-depth in another chapter.
|Passive income||Interest rate risk|
|Instant returns on your investment||Dividend payments can stop any time|
|Preferential taxes (taxed at lower rates vs bonds and stocks)||Less potential in capital gains|
|Mostly larger companies (low volatility)||High dividend yield traps|
|Tax inefficiency (you have to pay taxes over the dividends you receive if you reinvest them or not)|
4.4 Defensive stocks
Defensive stocks are stocks that do not fluctuate that much regardless of the current economic market. They are defending your investment by having a steady amount of growth. Defensive stocks are typically companies that provide products and services anyone needs despite the current financial situation. For example, everyone needs to eat and drink no matter what. Even in a big recession everyone goes to the supermarket to buy food and drinks. These stocks are also called non-cyclical stocks.
|Less vulnerable in bad economic times||Less overall value and growth (lower gains) in good economic times|
|Steady investment||Lower growth overall|
|Low volatility||Can be overvalued in bad economic times|
Chapters: The Ultimate Investing Guide
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