Become a better investor
Lesson in Course: Stocks (advanced, 5min )
With so many stocks to invest in, how do we choose?
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. Let's look at how they're organized based on the company's value. The stocks in each group will have similar risk and return characteristics.
Using a company's value helps us sort by the amount of risk. There are many ways to value a company, each with its own set of drawbacks.
The most commonly used measure is market capitalization (or market cap) because it's an easy starting point for a company's size.
A company's market cap represents the total value of its shares on the market. We calculate it using the formula below, but it's also easy to find from a quick internet search.
In general, companies with larger market caps tend to be less risky since smaller ones often have more challenges to overcome. This table shows us how we group stocks by market cap.
Large-cap stocks are companies with a market capitalization of $10 billion or higher.
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.
Mid-cap stocks are companies with a market capitalization between $2 billion and $10 billion.
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.
Small-cap stocks are companies with market capitalization between $300 million and $2 billion.
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.
Micro-cap stocks are companies with a market capitalization below $300 million.
Micro-cap stocks are the riskiest among the four. 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.
Getting familiar with these descriptions helps us identify investments that fit our needs. For example, a large-cap stock will be a better option if we want to buy stock with the least amount of risk. On the other hand, mid and small-cap stocks are suitable if we are going for the highest risk and return potential.