Every once in awhile, I write about terms and jargon used in the professional investing community. From what I’ve seen, often professionals will throw around sophisticated-sounding phrases in order to impress or even intimidate their customers. Since personal finance and investing are passions of mine, I enjoy taking time to learn what the pros are saying.
And 90% of the time, the concepts and jargon are relatively easy to understand. So today I’m going over four of the basic terms used to describe types of stocks and stock funds. Stick with me, they are really easy to understand. They will be worth learning, especially when you want to impress others at a dinner party.
Small Cap vs. Large Cap Stocks
One way that investors measure and compare stocks is by market capitalization (market cap). Market cap is the value of all the company’s outstanding stock, otherwise put, the value of all their stock on the market. So, if all the funds on the stock market were listed from lowest outstanding value to largest, the top half or third would be labeled large cap funds. Conversely, the bottom half or third would be labeled small cap funds.
Small and large cap are the most general market cap designations, investors also identify mid-cap funds and more recently, micro-cap funds. So why use market cap when talking about stocks? It turns out that certain trends and patterns follow market cap. Historically, small cap stocks have had higher rates of return than large cap ones. If we remember the relationship between risk and return (higher risk = higher possible return and vice-versa), it makes sense that smaller companies, which are (in general) riskier than large ones, would offer a higher rate of return.
Value vs. Growth Stocks
Another way investors stratify the thousands of stocks and funds is by the distinction between value and growth. Put simply, “good” companies are labeled growth stocks and “bad” companies are “value” stocks.
Now for the most counter-intuitive statement in this post: good companies have bad stocks and bad companies have good stocks. Follow me as I walk through the reasoning and hopefully you’ll agree by the end.
In The Four Pillars of Investing
Remember the relationship between risk and return that we just talked about? Since K-Mart is a riskier company, it offers a higher rate of return. Think about it: if K-Mart’s stock offered the same return as Wal-Mart’s, then no one would buy it! Why buy a riskier stock when a safer one offers the same return? So, value stocks (bad companies) are riskier than growth stocks and they offer a higher return.
Wrap-Up
Small vs. large cap. Growth vs. value funds. These are just a couple of the ways professional investors slice and dice the stock market. Weren’t they easy to understand! Next time you’re at a party, drop a few of these terms. You are no longer a member of the ignorant, unwashed masses. I guarantee you’ll make friends and influence people.
Tags: growth versus value, market capitalization, The Four Pillars of Investing, William Bernstein
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I'm Damien Olenslager. I recently graduated debt-free from college and now work in the tax industry.
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