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.
McDonald’s has a huge and varying global footprint with stores in a jaw-dropping 120 countries, including Curacao, Sweden, Andorra, Luxembourg, Estonia, Oman and so many more. Yum! Brands pockets around half of its revenue from China. Smaller fast-food companies like Sonic (NASDAQ:SONC) and Jack in the Box (NASDAQ:JACK) have a solely domestic presence.
Why is this important? Well, imagine you had a number of stocks of varying sizes and sectors, but they all got most of their revenues from Europe. Chances are you would have had a rough ride in the past few years. However, holding companies with more global diversity — or holding different companies with different regions of exposure — would keep your whole portfolio from hurting when a single region slumps.
Last but not least, stocks vary based on investment styles — how investors expect the stock to improve their return. The growth/value dichotomy is one good example.
“Growth stocks” are exactly what they sound like: They’re companies that grow revenues and ideally earnings at a high rate relative to other companies. That includes stocks like Michael Kors (NYSE:KORS), which is expected to grow earnings by 77% in the current quarter — twice what’s expected on average from companies in its industry. And investors hoping to get into the big Kors growth story have bid the stock up more than 100% since the start of 2012.
However, other investors are attracted to “value stocks” — companies whose prices might not reflect their strong businesses. Investors buy these stocks with the hopes share price will increase as the market realizes the full potential and fair value of the company. Value stocks are identified by low readings in valuation metrics such as price-to-earnings or price-to-book value.
Another category is “income stocks” — companies that regularly pay out part of their earnings directly in the form of cash dividends to investors, thus providing a steady stream of income. The important term to know with income stocks is yield — the annual amount paid in dividends divided by the share price. McDonald’s yields 3.2%, which means that if the stock were to stay the same price all year, the investor still would enjoy a return of 3.2% in the form of these cash payouts. A good place to start on the income path is our list of Dependable Dividend Stocks — a group of companies that have not only paid out dividends for decades, but have increased the amount they pay out year after year.
Keep these four basic considerations in mind when selecting stocks, and you’ll be on your way toward building a portfolio that can grow your money without exposing you to unnecessarily high risk.
As of this writing, Alyssa Oursler was long MCD.
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