Different types of stocks and stock classifications are suitable for different types of investors. While stocks like Facebook and Amazon, which are categorized as common stocks, grab headlines on financial news networks, other types of stocks called preferred stocks may be a better bet for more risk-averse investors.
Depending on your appetite for risk, different stock classifications may be better suited to your financial goals. Growth stocks, blue chip stocks, defensive stocks, speculative stocks, income stocks, and value stocks are among the various stock classifications from which you can choose.
So how do you decide between common stock vs preferred stock and which stock classifications are best suited to your financial aims?
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Common Stock vs Preferred Stock
Common stock and preferred stock are among the different types of stocks that give shareholders partial ownership in companies.
While these two types of stocks are similar in many ways, they differ with respect to ownership rights.
Most stocks that ordinary investors come across are common stocks, which entitle shareholders to a share of the company’s profits through any dividends paid as well as any capital appreciation.
The number of shares you own directly relates to the number of votes you receive.
You can cast these votes to elect members of the board who in turn can decide to pay dividends to shareholders.
As a common stock owner, you also receive pre-emptive rights to maintain the same percentage ownership share over time. For example, you can buy more stock to maintain your proportion of ownership if the company chooses to issue more stock via a secondary offering.
The most important thing to note when you own common stock is that your gains and losses are heavily tied to share price movements. If a company pays no dividends then your fortune will be tied exclusively to the whims of its share price.
Because the ups and downs of a company’s share price can significantly affect your wealth, and the fact that you have no control over whether a company pays a dividend, you should carefully monitor your risk tolerance and capacity for risk before investing in common stock.
On the risk totem pole, owners of common stocks take on the most risk. If a company enters bankruptcy, bondholders and preferred stockholders get paid first.
To lower the risk of any single company hurting your portfolio in a big way, consider diversifying your portfolio. Robo-advisors like Betterment and Personal Capital do this automatically for you. Or you can buy ETFs from major brokers like thinkorswim or tastyworks.
As an aside, if you trade outside the United States, such as in the UK or Commonwealth regions, common stock may be better known as Equity Shares or Ordinary Shares.
Preferred stock is considered to be a bit safer than common stock but the upside is generally lower.
Unlike common stockholders, preferred stockholders don’t usually receive voting rights but they do have a greater claim to a company’s assets.
Preferred stockholders usually receive higher dividend payments compared to common stockholders and get paid sooner.
Plus, the dividends paid to preferred stockholders tend to be more predictable. Unlike common stockholders, whose dividends may vary depending on policy changes made by a board of directors, preferred stockholders usually receive a regular dividend that is fixed for a specific time period.
Some investors like preferred stock because of this predictability in income while others shun it because shares are often callable, meaning the company can buy back shares from shareholders at any time specified.
If you are willing to take on more risk, common stock usually has greater upside while preferred stock is usually more suitable for more risk-averse investors who prioritize income predictability.
What Are The Different Types Of Stock Classifications?
When you buy stocks, you can choose from different types of stock classifications, including:
- Value stocks
- Income stocks
- Defensive stocks
- Growth stocks
- Penny stocks
- Blue-chip stocks
Perhaps the most famous value investor of all time is Warren Buffett. He shares investing lessons each year in his annual Berkshire Hathaway shareholder letter that are well worth checking out if you are keen to invest patiently over the long-term.
If you want to follow in the footsteps of successful value investors and find out how Warren Buffett got so rich, you will need to understand the difference between when stocks are cheap and when they are undervalued.
The key metric that successful value investors focus on is intrinsic value, which tells you what a company is really worth.
When a company’s intrinsic value is higher than its share price, the stock may be undervalued and vice versa when the intrinsic value is below the share price, the stock may be overvalued.
Intrinsic value is sometimes called fair value. For Amazon stock, you can view the fair value below:
Professional investors and Wall Street research analysts generally calculate intrinsic value using discounted cash flow forecast models. Thankfully, you don’t have to break out a spreadsheet and analyze financial statements because companies like Finbox have done the hard work for you.
Ideally, a good value stock is not only one that is undervalued and has upside potential but also has what Warren Buffett would call a moat, meaning that the company can sustain its competitive advantage to protect market share and long-term profits.
Some companies, like Facebook, have moats in the form of network effects. You are probably a Facebook user because your family and friends are on the site. Even if a company built a better technology than Facebook, the likelihood is you wouldn’t leave the leading social media platform because the people with whom you have close relationships are there.
A company like Walmart or Amazon has a different type of moat. Those consumer companies are known for low-prices and attract customers who are price-sensitive.
Value stocks that are on sale with defensible moats are not immune to stock market crashes but over the long-term they have a history of outperforming as Berkshire Hathaway has demonstrated.
As you grow older, your capacity for risk usually diminishes and it becomes ever more important to focus on income over capital appreciation.
While dividend-paying stocks offer one path to earning a steady income from your nest-egg investments, another option is to purchase a corporate bond fund or even a Vanguard fund that provides a consistent income stream.
Research from Professor Jeremy Siegel of the Wharton School of the University of Pennsylvania has shown that as much as 95% of stock market returns over the last century were attributable to compounded gains from dividends.
So even though buying stocks in the hopes that they rise in value is a noble goal, smart investors know how important it is to prioritize income.
A growth stock is expected to generate returns in excess of a company’s cost of capital.
These stocks tend to rise faster than the overall stock market but equally they can be more sensitive to interest rate changes from a Fed rate hike and so fall faster too.
Growth stocks tend not pay dividends because management believes they can re-invest earnings to produce higher returns than shareholders can earn elsewhere if dividends were paid.
If you like the rollercoaster ride that a growth stock can provide, a blue-chip stock may seem downright boring to own. But don’t let that deter you from considering these slow-and-steady stocks.
Blue-chip stocks are favored by wealthy investors and institutions because their revenues, profits, and dividends tend to be comparatively stable and predictable.
The common features of blue-chip stocks include:
- Long history of stable dividend payments to shareholders
- Dividend payout increases that meet or beat the rate of inflation
- Stable earnings power over many decades
- Usually a large corporation by market capitalization and member of S&P 500
Blue-chip stocks are generally the best known companies in the United States, such as American Express, AT&T, Coca-Cola, General Electric, McDonald’s, Procter & Gamble, Visa, Walt Disney Company, and Wells Fargo & Company.
Although the companies of blue chip stocks are known for having solid financials, they are not immune from stock market shocks. For example, General Electric stock has had a history of losing half its value at different times in its operating history.
Nevertheless, the long-term returns from holding a portfolio of blue-chip stocks have been stellar and are best suited to investors who want exposure to equity markets yet lean towards being more risk-averse than risk-seeking.
Defensive stocks should not be confused with defense stocks. The latter are stocks of companies like Lockheed Martin, Boeing, and Northrop Grumman. However, the former are stocks that are expected to perform better than the overall market during bear markets.
When dark clouds loom over the economy and a downturn is expected, defensive stocks can provide a relative safe haven.
These stocks won’t necessarily rise during bearish markets, though they may be more likely to do so than the average stock in the Russell 2000, NASDAQ, Dow Jones, or S&P 500.
If you like the idea of earning an income while lowering portfolio risk during downturns, defensive stocks can be a good portfolio fit.
For risk-seeking investors, penny stocks can provide the adrenaline rush that blue-chip and income stocks rarely offer.
Penny stocks usually trade over-the-counter (OTC) on the pink sheets.
The underlying companies do not always have proven business models so the risk of them failing is significantly higher than say a blue-chip stock, which is why you don’t see penny stocks much on the New York Stock Exchange.
If you are attracted to penny stocks for the potential for big returns, it is best to consult with your financial advisor to see if they are suitable. Usually, it is recommended to apportion only a small percentage of a portfolio to such speculative stocks.
On the other hand, if you prefer a hands-off approach to investing yet want all the benefits of diversification, a robo-advisor like Betterment or Ellevest may be a great fit.
Have you invested in different types of stock? Which stock classifications do you think are best to maximize wealth over the long-term? Share your comments with us, we love hearing from you.
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