Diversification is an important strategy for every portfolio. But unless you understand the different kinds of companies in the market, you may end up less diversified than you think. With the economy possibly poised to turn around, here are eight categories you should know about.
The best defense
Cyclical companies are strongly affected by the state of the economy. During recessions, people tend to put off big-ticket purchases such as cars, computers, washing machines, and vacations. Construction also slows down, crimping the fortunes of retailers and building-materials makers.
As we emerge from our most recent recession, cyclical companies such as Home Depot
Meanwhile, companies that don't react much to economic change are considered defensive stocks, including pharmaceutical, food, and utility companies. If you're taking heart medication, you won't stop because of an economic downturn, nor will you cut back significantly on lighting your house or buying milk.
For every stock, there is a season
Seasonal companies fluctuate like cyclical ones, but on a much more predictable basis. They consistently experience significantly different levels of business at various times of the year. Department stores, for example, see sales surge during the Christmas holiday season. Swimming-pool companies see large sales and profits mainly in the summer.
Chips of many colors
Blue-chip companies tend to be old, established names such as Merck
The opposite of steady, stable blue chips are speculative stocks, typically tied to young, relatively unknown, and risky companies. Many promise great things, but have yet to prove themselves. Examples might include gold mines or companies trying to develop cures for cancer. Penny stocks represent a generally dangerous subset of this category.
It's good to have a mix of small, medium, and large companies in your portfolio. Smaller ones have the greatest growth potential, while many blue chips offer more stability. During some periods, large caps will shine; during other periods, you'll want to own small caps.
Growth and value
You can also classify companies along the continuum between growth and value.
Growth stocks grow faster than the market average, a la Amazon.com
Value stocks are favored by more conservative investors, who seek the proverbial "dollar for $0.50." Value investors hunt for companies that are temporarily out of favor -- cruise-ship operators temporarily troubled by an unusually robust hurricane season, for example, or an automaker beset by short-term bad publicity and quality-control problems.
Growth and value don't have to be at odds. We should ideally seek both in our investments: companies growing at respectable rates, yet priced significantly below their intrinsic values.
Still, it's helpful to understand the growth and value categories so that you can better calibrate your tolerance for risk. Daring investors will likely seek growth stocks (although a few value investments can protect your portfolio from growth stocks' ups and downs). If you're risk-averse, undervalued stocks can often give you great performance with far less volatility.
Finally, income stocks -- often blue chips such as Sysco
An effective portfolio often includes a healthy mix of stocks: large-caps and small-caps, domestic and international issues, dividend payers and rapid growers. (You'll probably want to skip the penny stocks, though.) A diverse array of high-quality investments will let you make the most of the market, whatever it happens to favor at the moment.
Longtime Fool contributor Selena Maranjian owns shares of Home Depot. Home Depot and Sysco are Motley Fool Inside Value picks. Amazon.com is a Motley Fool Stock Advisor recommendation. The Fool owns shares of Sysco, which is also a Motley Fool Income Investor recommendation. Try any of our investing newsletter services free for 30 days. The Motley Fool is Fools writing for Fools.