I recently introduced you to the importance of asset allocation. In order to help you determine the right asset allocation, I figured I’d spend a few moments introducing the different types or categories of stocks and the general trademarks that represent each type.
The best primer book on this topic is The Sound Mind Investing Handbook by Austin Pryor. My comments on the book exactly mirror those of Mary Hunt who says, “Everything I know about investing I learned from Austin Pryor.”
Small Companies Vs. Large Companies
In one corner, we have Wal-mart. (Ever hear of them? I think I may have seen one before.) In the other corner, we have Ralph’s Revolutionary Raft Corporation.
Wanna guess which is the small company and which is the large?
Now, the biggest question is which type of company provides more opportunity for returns, and which provides more opportunities for losses?
Wal-mart is a big company. They are more stable and consistent. It doesn’t mean that they can’t, won’t and don’t lose money. It simply means they are more established, and thus, more predictable.
Ralph, on the other hand, could easily triple or quadruple his sales (and stock value) if everything goes right. However, he could go all in and bust too.
A mutual fund company or index fund that owned lots of Wal-mart type companies would be categorized as a Large Cap or Large Company. On the other hand, a mutual fund company or index fund that was more interested in Ralph’s Revolutionary Rafts would be categorized as Small Cap or a Small Company.
What if they own both?
Typically, they would be called mid-cap or would be identified by whatever is the bigger focus.
For those of you who are more familiar with Dave Ramsey lingo, Large Cap is what he calls Growth and Income Funds or Blue Chip Funds.
Growth Vs. Value
Going one step further, different mutual fund managers have different strategies. (You won’t get into this type of distinction with index funds as index funds will own both growth and value companies.)
The value managers look for companies whose shares are selling below what they are ‘worth’. The management team will determine what represents a value and then buy up shares at a discounted price.
Growth managers look for companies with a solid track record and good potential for growth. They are willing to buy stocks at top dollar because the company has been, and is expected to perform well into the future.
Once again, some managers do both, so this may be identified as a ‘blend’ fund.
International funds try to identify growing markets and economies outside of the USA. They also attempt to take advantage of currency difference to maximize their returns.
In this final category you must remember that you can have each of the above types of companies with the only constraint that they will focus their investing outside of the United States.
Thus, you could invest in an international small growth stock or an international large value international fund.
What’s the difference between global and international?
Global funds are given more flexibility to invest both in the US and outside of the US, whereas international funds primarily invest only outside the US.
Sector funds only invest in one part of a given economy. They might focus on automobiles, medical care, precious metals … Thus, these types of mutual funds or ETFs would only buy stocks that belong within the specified sector of the economy.
One could categorize the risk levels as follows:
- Large Value (least risk)
- Large Growth
- Small Value
- Small Growth
- International Funds
- Sector Funds (greatest risk)
For those of you who are currently investing, your homework is to be sure that the index funds or mutual funds that you own represent your current risk level. If not, it’s time to adjust your holdings.