Option Investor

Covered-Calls 101

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Stock Buying Basics

Over the past few days, there have been numerous articles about portfolio diversity and the need to own specific groups of stocks such as cyclical or defensive companies during periods of bearish market activity. To be sure, the recent slump in the stock market suggests it is prudent to have a wide variety of issues in your brokerage account. In order to achieve this objective, an investor must understand how the different types of stocks are classified with regard to risk, income or profit potential, and quality.

Stocks are grouped in many different ways but for retail investors, the most common categories are: blue-chip stocks, growth stocks, income stocks, cyclical stocks, defensive stocks, speculative stocks, and hard assets.

Blue-chip stocks are historically the best long-term investments. These companies are well established, high quality businesses such as AT&T, Boeing, Disney, McDonalds, General Electric, and International Business Machines. They generally pay good dividends and are considered the bellwethers of the market.

Growth stocks are those companies which have a high probability of capital appreciation. They retain most of their earnings and usually don't pay dividends. All of their available funds are plowed back into the company for future expansion and acquisition or research. These stocks are usually more volatile and are generally considered aggressive investments.

Income stocks are typically classified as conservative assets because they have yields comparable with corporate bonds. Their products or services are superior to others in the industry, thus they can issue competitive dividends and still offer the possibility of price appreciation.

A cyclical company is one whose earnings fluctuate with changes in a particular business or industry cycle. When economic conditions are favorable, the company's stock and earnings rise. As the cycle comes to an end, the company's revenues and share value typically return to previous levels.

Defensive or "safety" stocks are those whose share values remain stable even in declining markets. Companies in this group often include utilities, drug manufacturers, and consumer non-durables or food producers. They hold their value in recessions because their products are always in demand, regardless of the economic climate.

In the past, speculative issues were generally identified by their P/E ratios. Stocks were considered especially aggressive when they had price to earnings ratios in multiples of 50 to 100. Now, many popular companies have P/E's well into the hundreds and some experts believe this historic fundamental indicator may no longer be an accurate measure for gauging investment risk.

Another type of high-risk asset is the new issue, more commonly known as the "IPO" or Initial Public Offering. These stocks can have incredible volatility when they begin trading and may move from just a few dollars up into the $100's over the course of a few week's activity. Obviously, they are the most speculative of all equity categories and the people who own inside (or pre-market) positions are often the only ones who profit.

Finally, there is the hard asset or commodity-based stock. The value of these issues is generally dependent on the price of certain natural resources such as fossil fuels, minerals, or a precious metal like gold or silver. Hard assets are typically used as a portfolio hedge in trending markets or when a particular commodity is expected to rise in value in the future.

Regardless of the type of stocks you favor, diversification is the key to achieving consistent success across a range of market conditions. In fact, many experts believe a conservative portfolio should contain at least 10 to 15 stocks from five or more industry groups in order to be truly diversified. Although this objective may not be viable for all investors, the important concept is to strive for some type of balance in position selection that will reduce downside potential during bearish cycles.

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