Over the history of financial markets, stocks have always beaten the performance of any other major asset class by a considerably wide margin. Since 1926 stock on average has provided an annual return of 10%, a period which has included economic recessions and major wars. It’s also a period that overlaps the great recession. 

Despite all these, stocks have proven their worth and thus deserve a place in anyone’s long term investment plan. But stock investment involves a lot of risks, primarily because of their volatility. Luckily because of diversification, an investor has an option to pick numerous kinds of stocks to diversify their stock holdings and overall portfolio. 

How to Select Stocks in the first place?

There are two basic approaches when it comes to picking a stock. The first one is known as a top-down approach which involves assessing economic and market factors. The second one if known as a bottom-up approach that revolves exclusively around analyzing individual stocks. Investors which can include mutual fund managers sometimes use a combination of both approaches when selecting a stock.

Top-down approach

In a top-down approach, investors start by analyzing the economy, markets, and industries. Employment, interest rates, and other trends in the economy can influence company earnings. The analysis must be global in scope since many big companies operate on a multinational level. 

Stocks have a tendency to perform differently at different points of an economic cycle. For example, homebuilders and financial companies often perform well early on in the recovery of an economy or when recovery is anticipated. On the other hand, companies that produce commodities such as chemical or aluminum manufacturers tend to perform well in the later stages of an economic cycle, usually when inflation increases and they have a chance of charging higher for their products.  

Bottom-up Approach

Under this approach, there are numerous ways to pick individual stocks with some of them being quite complex. However, in general, investors have a preference for companies that deliver solid earnings growth. They can also choose companies whose share prices are cheap, relative to the perceived value of the organization. 

You can use the P/E ratio as an accurate reflection of how much investors are willing to pay for each dollar a company earns. Look for stocks with a high P/E ratio, which is calculated on the basis of estimated future profits. 

Different types of stocks

Cyclical stocks

Cyclical stocks are shares of companies whose sales and earnings show high sensitivity to the ups and downs of the economy. In a well-performing economy, cyclical companies tend to succeed. In a contracting economy, however, the profits of these companies are decreased which in turn hurts their stocks. Companies involved with steel manufacturing, automobile production, chemicals, airlines, and home building industries are all cyclical in nature. 

Growth stocks

Growth stocks refer to the shares of companies that have the potential to consistently generate above-average revenues as well as profit growth. These companies tend to reinvest the majority or all of their earnings into their own business. As a result, they tend to pay out comparatively little in the form of dividends. Companies in this category experience faster expansion than the overall economy. However, you have to remember that not all fast-growing companies are not necessarily good investments in case the shares are overhauled. 

Foreign Stocks

Foreign stocks can be a source of valuable diversification in a purely domestic stock portfolio. This is mainly due to foreign and US stock markets, not mobbing in sync. Foreign stocks can provide you exposure to overseas currencies, business cycles, and economies. Overseas stocks are usually of two types: stocks from developed markets such as Japan, Canada, and Western Europe and stocks from faster-growing emerging markets like that of China, Brazil, and India. 

Defensive Stocks

Defensive stocks refer to shares of companies where the sales of goods and services hold up well in times of economic uncertainty and downturns. These include industries such as government contractors, utilities, and producers of basic consumer products, all of which are insulated substantially from the effects of business cycles. 

Small-company stocks

There are any small stocks that have generated more profit compared to larger companies. These stocks mostly belong to young, smaller companies that tend to grow faster. However, stocks of this category tend to experience much more volatility. There are many ways in which one can define a small company. One of the most common definitions defines small companies as one with a market capitalization of less than $1 Billion. 

Income Stocks

Income stocks pay dividends which are a large percentage of their earnings. The companies belonging to this category include those which are matured and have limited opportunities to reinvest their profits elsewhere. These stocks are usually less volatile as investors regularly receive cash dividends regardless of what the market is experiencing.  

Value Stocks

Value stocks include any stock which is cheap in relation to fundamental measures such as sales, profits, the value of the company’s assets, and cash flow. 

The Importance of Stock Diversification

For diversification in stocks, you will need to buy a minimum of 20 to 30 individual company stocks from a variety of industries. If you choose to invest in a diversified stock mutual fund the fund automatically achieves this diversification for you. 

For example, you might want a mix of stocks that have a tendency to fare well under different economic environments (strong, inflationary, or stagnant). You can do this by blending growth with income stocks, along with adding some small company and emerging market stocks. Your appropriate blend of stocks will depend on your personal preference and circumstances. This includes your risk tolerance and volatility.

Conclusion

Diversifying through stocks is a very good way of earning profits by using a less risky method. However, the process of picking the right balance of stocks can be tricky and appear daunting especially if you are a newcomer. This is one of the reasons why you should consider investing through stock mutual funds. You effectively hire an investment professional who makes the diversification decisions on your behalf.