A well-diversified portfolio of stocks contains shares in many different types of companies. Diversification is important because at any given time market and economic conditions are likely to benefit some types of companies more than others, so diversification can make a portfolio more stable. To build a diverse portfolio, it helps to understand some of the ways that investors categorize company stocks.
By size. A company’s size is generally measured by its “market capitalization,” which is the current stock price times the total number of shares. (You can also think of it as how much investors believe the company is worth.)
Company size is usually described as either “large-cap,” “mid-cap” or “small-cap.” The precise definitions of these categories vary and change over time, but large-cap companies generally have market capitalizations in the tens of billions of dollars. Their growth potential tends to be more modest, and their prices more stable, than those of small-caps.
Small-cap stocks, with market capitalizations below about $2 billion, usually offer more growth potential, and have prices that are more volatile, than do large-cap stocks. (Mid-caps, of course, are in the middle.)
By sector or industry. Standard & Poor’s breaks stocks into 10 sectors (consumer staples, energy, financials, health care, etc.) and, within those sectors, into dozens of industries and sub-industries.
By geography. Some U.S. investors choose to diversify their stock portfolios by purchasing shares of companies based outside the U.S. Companies located in so-called emerging markets, in particular, offer strong growth opportunities, but also relatively high levels of volatility and risk.
By “style”: growth or value. Though some offer both of these qualities, most stocks can be classified as value or growth. Value stocks are characterized by low share prices relative to commonly used measures of value, like earnings per share – in other words, they are “cheap.” They tend to be larger, slower-growing companies with relatively stable earnings. Those who buy value stocks often believe the company is not fully appreciated by investors at large — but that more investors will soon come to see the true value and the price will increase as a result.
Investors buy growth stocks, by contrast, because they believe the company’s earnings will grow substantially in the future, thereby justifying their relatively high prices. Growth stocks tend to be smaller and newer companies in fast-growing sectors like technology, and they’re relatively volatile compared to value stocks.