What types of stocks carry more risk than others? Higher risk stocks include cyclical and growth stocks, and lower risk stocks include income and defensive stocks. By their very nature, all stocks carry...
By their very nature, all stocks carry some risk. Investors put their money into a company, enabling the company to grow or sustain itself, and the investor hopes for generous returns. Companies vary, though, in many ways. They vary in the ways they operate, the industries they belong to. They vary in size and goal and sustainability. So knowing what kind of stock carries higher risk will help you as you build and diversify your portfolio.
Higher risk stocks include cyclical and growth stocks, and lower risk stocks include income and defensive stocks. Below you will find brief summaries of these four types of stocks and why they are high or low risk:
Growth stock is stock from a company that is growing earnings and/or revenue faster than its industry or the overall market. Such companies usually pay little or no dividends, preferring to use the income instead to finance further expansion. Therefore, the stock yields a high return on equity (ROE). To be classified as a growth stock, the stock must yield at least 15 percent ROE.
Another definition of a growth stock is a stock that is looking to capture rapid revenues. This may come at the expense of their earnings-per-share. As soon as they have generated a lot of money, they reinvest it into the company to aid expansion.
Because companies that are expanding face more risk than steady, older companies, their stock is considered high risk. Generally speaking, though, growth stocks usually out-perform slower-growing companies over the long haul.
Cyclical stock is stock from a company that is sensitive to business cycles and whose performance is strongly tied to the overall economy. Cyclical companies tend to make products or provide services that are in lower demand during downturns in the economy and higher demand during upswings. Examples include the automobile, steel, and housing industries. The stock price of a cyclical company will often rise just before an economic upturn begins and fall just before a downturn begins. Investors in cyclical stocks try to make the largest gains by buying the stock at the bottom of a business cycle, just before a turnaround begins.
Now, on to the lower risk stocks:
Income stocks are stocks that have a history of consistently paying high dividends in relation to the market price of the stocks. Public utilities, telecommunications, and financial management firms are most often associated with income stocks because of their high dividend payout ratios. Traditionally, many of the companies offering high dividends are mature companies that aren't expecting growth. Therefore, they don't need extra money for building, equipment, etc.
Because such companies are stable and not expanding, prices of income stocks have tended to be flat. But recently, income stocks have been doing quite well. Dividends were out of fashion for many years, but they made a big comeback during 2002 and 2003, perhaps reflecting investors' desire to find a save haven during the dark days of a bear market.
A defensive stock is a stock that tends to remain stable under difficult economic conditions. Defensive stocks include food, tobacco, oil, and utilities. These stocks hold up in hard times because demand does not decrease as dramatically as it may in other sectors. Defensive stocks tend to lag behind the rest of the market during economic expansion because demand does not increase as dramatically in an upswing.
To better your chances for high yields, invest in growth and cyclical stocks. But don't be surprised if you lose big every now and then. To put your money somewhere safe, invest in defensive and income stocks.
