So, you’ve gotten over your investing fears and bought your first stock. Now what?
OK, OK, this seems like a glaringly obvious piece of advice, but when it’s your first rodeo, it’s not as simple as it seems.
If you remember, my first investing move (outside my 401k) was to buy a company I’m quite familiar with in my day-to-day life: fast-food king McDonald’s (NYSE:MCD). Well, that decision will actually have a big influence over my next purchases as I try to achieve a very basic but important quality in my portfolio: diversification.
Diversification — which simply means investing in different things — has two levels:
- Diversification between asset classes: You don’t want to hold just stocks, but also cash, bonds and even alternative investments like real estate.
- Diversification within asset classes: Even within one asset class — say, stocks — you don’t want to have a handful of similar holdings.
Right now, I’m focusing on diversifying within the stock world, so let’s look at a few qualities to consider while building up a stock portfolio.
This is just what your company does to make money. In my case, McDonald’s — details like price, cuisine and format aside — is a restaurant stock. For a couple of reasons, that means my second stock probably shouldn’t be, say, Burger King (NYSE:BKW) or Wendy’s (NASDAQ:WEN).
For one, those companies directly compete with another another — while there’s no perfect push-and-pull, one’s gains very well could be the others’ pain to some extent.
But more broadly speaking, I also should protect myself in the event that some larger force negatively affect fast-food restaurants in specific, and restaurant stocks in general. (Think about how bank stocks plummeted in value during the financial crisis.) Thus, I also should avoid even slightly different sectormates such as Chipotle (NYSE:CMG) or KFC/Taco Bell/Pizza Hut parent Yum! Brands (NYSE:YUM).
The broadest organizational level of stocks is the sector. Standard & Poor’s, for example, divides stocks into nine sectors: energy, consumer staples, consumer discretionary, healthcare, financials, materials, industrials, utilities and technology. That’s a good starting point when looking at how you can diversify your holdings.
However, looking another level deeper, there’s also different industries or markets within each sector. In retail, for instance, you have discount operators like Walmart (NYSE:WMT), but also high-end retailers like Tiffany & Co (NYSE:TIF) — at the most basic level, they both sell goods, but what they sell and who they sell it to are very different.
The size of a company is measured by what’s called “market capitalization,” which is the total value of all the shares issued. The most frequently used sets of stocks by market cap are:
Mega caps: $50 billion-plus (McDonald’s, a $97 billion company, is in this group)
Large caps: $10 billion-$50 billion
Midcaps: $2 billion-$10 billion
Small caps: Less than $2 billion
(Note: not everyone uses the exact same figures, and small caps can be broken down further, into microcaps and nanocaps).
What’s important here is that different-sized stocks often behave differently, too. Large-cap stocks usually are more established companies — thus there’s usually less room for the company (and stock) to grow, but less risk of the company just falling apart overnight. On the other hand, smaller businesses tend to have fewer financial resources (making it harder to withstand soft economies), but they can grow at much more rapid rates. After all, it’s much easier to double your sales from $10 million annually than from $10 billion annually.
During the marketwide run at the start of 2013, for example, small- and midcap stocks led the way up … but also led the way down when stocks pulled back towards the end of last month. However, it’s worth noting that over the last few decades, mid-cap stocks have actually outperformed both their smaller and larger peers once you factor in risk.
How much of your portfolio is dedicated to each size comes down to how much risk you’re willing to take, but most accounts have some mixture of large-, mid- and small-cap stocks.
Another thing to consider: Where business is being done.