Different Classifications of Stocks and How They Relate to Risk

20 October 2020 by TMX Group
Portfolio diversification

From blue-chip stocks to speculative stocks, there’s something for every investor based on comfort level and desired outcome. Some stocks come with high levels of risk but offer investors the opportunity to double or triple their return in a short time. Other stocks are expected to gradually rise in value while paying out a very stable dividend. And then there’s everything in between.

No One-Size-Fits-All Approach

There is no single formula to determine what stock types should be bought by investors. Younger people are more often able to absorb losses from higher-risk stocks because they are decades away from retirement. On the other hand, investors close to retirement age may want to protect their money at all costs because a large loss could be devastating to their retirement fund. Conversely, a young investor may have limited financial resources as well as near-term financial objectives (e.g., down payment on a house) that would make risky investments untenable. Moreover, someone older and more established may be in a better position to absorb investment losses.

Here is a breakdown of various stock classifications:

  • Penny Stock - Consists of companies of all shapes and sizes and across all industries. However, the term is mostly reserved for very small companies. Savvy and skilled investors will comb through dozens of penny stocks at a time to find a company undervalued or overlooked by the majority of investors. Finding a winner can offer investors big returns over time as other investors begin to understand the stock’s true potential.
  • Blue-Chip Stock - The complete opposite of a penny stock, since it refers to elite companies with valuations in the tens of billions of dollars. The term derives from the world of gambling: in a set of poker chips, the blue-coloured chip is worth the most. Blue chip companies are often industry leaders. Younger investors often think of them as boring, but these stocks are popular among older investors because they typically offer more safety and a steady dividend payout.
  • Income Stock - As the name implies, an income stock refers to any stock that generates income for the investor, usually in the form of dividends. Income stocks pay investors a dividend yield that often ranges from as low as 2% of the stock’s total value to as much as 15% a year. Income investors typically don’t expect to see much or any additional gains from the stock’s appreciation. Many investors take advantage of income stocks since the Canadian tax code offers special treatment for dividends. For example, investors in the highest tax bracket pay around 50% on interest income, but they only pay 29% on dividends. 1
  • Growth Stock - Companies that are expected to expand their business at a much faster rate compared to the average. Established banks or telecom operators typically show minimal if any growth because of the very mature state of the market they operate in. On the other hand, cloud computing companies or those working in artificial intelligence could show a triple-digit percentage growth rate for years, since these types of markets are still in their infancy.
  • Speculative Stock - Penny stocks and growth stocks are regarded as speculative, along with any type of stock with generally uncertain prospects. A speculative stock is one that investors think may perform well, without much concrete evidence to support this conclusion. Investors with low tolerance for risk mostly stay away from speculative stocks because the downside potential could be significant if the investor turns out to be wrong.

Obviously, investors are not bound to limit their choices to a single category of stocks. The composition of their portfolio can easily accommodate a whole slew of securities provided that its allocation respects their degree of risk tolerance and the investment objectives they set for themselves.  

[1] Percentage may vary by province.

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