The main goal of stock investment is to provide growth and to earn returns in excess of inflation. The stock market has historically been the only investment that has consistently outpaced inflation in the long run; from 1926 through year-end 2006, large-capitalization stocks have earned an average 10.4 percent compound annual return, while small-capitalization stocks have earned an average 12.9 percent compound annual return. When you buy a share of stock, you are buying ownership in a business’s earnings and assets. You therefore receive a proportionate share of the profits through dividends and benefits that stem from increases in the company’s share price. Mature companies are typically a better source of dividends, since rapidly growing companies often prefer to invest profits.

Table 2

Source: Ibbotson Associates, Morgan Stanley Capital International, NA = not available

Equity asset classes are mainly classified by three factors: market capitalization, type of company, and geographic location.

Market capitalization: Market capitalization is one way of measuring the size of a company. Market capitalization is calculated by multiplying the market price of the stock by the number of shares, or the number of ownership pieces outstanding. Market capitalization is used to separate companies into specific ranges of company size and to determine certain classes of companies. These classes include large-capitalization (large-cap) companies, middle-capitalization (mid-cap) companies, and small-capitalization (small-cap) companies.

Large-cap stocks are generally defined as stocks from companies with a market capitalization that is greater than U.S. $10 billion (this amount is smaller for international companies). Large-cap stocks generally come from large, well-established companies that have a history of good sales and earnings, as well as a notable market share. Although large-cap stocks have traditionally been synonymous with dividend-paying companies, this classification is no longer standard. Nevertheless, large-cap stocks do generally entail mature corporations with long track records and a steady growth of dividends.

Companies that offer mid-cap stocks have a capitalization that is roughly between U.S. $2 billion and U.S. $10 billion. These stocks tend to grow faster than large-cap stocks, and they are generally less volatile than small-cap stocks. Mid-cap stocks generally perform in a similar manner to the small-cap asset classes. For asset allocation purposes, mid-cap stocks are not generally considered a major asset class.

Companies that are small-cap stocks generally have a market capitalization of less than U.S. $2 billion. They are small (or sometimes newer) U.S. and global companies that are still developing, so they have a smaller market share than their large-cap counterparts. Small-cap companies are subject to greater volatility in stock price, and they tend to fail more frequently than larger companies; however, they are generally expected to grow faster than larger companies.

Type of company: Within the large-, mid-, and small-cap stock categories, there are two separate types of stocks: growth stocks and value stocks. Growth stocks are offered by companies whose earnings are expected to grow much more rapidly than the market. In the United States, the proxy or benchmark for the U.S. equity market is sometimes considered the Standard & Poor’s 500 Index. These companies frequently focus on developing new technologies.

When compared to the market, value stocks are cheap stocks, at least in terms of low price earnings and low price-to-book-value ratios. These terms are explained in Section 21: Investments 4: Stock Basics of this website. Value stocks are offered by companies that have potential for good long-term returns through both capitalization appreciation and dividends; they have this potential because they are inexpensively priced in relation to the market.

Location: Stocks may also be classified according to location. International stocks are stocks outside the United States. Global stocks are stocks that are either international or in the United States. Regional stocks are stocks from a specific region, such as Europe or Asia. Emerging market stocks are stocks from countries that are not considered developed. International investments involve additional risk, such as differences in financial accounting standards, currency fluctuations, political instability, foreign taxes and regulations, and the potential for illiquid markets.

Stock mutual funds are funds that own stock in specific groups or types of companies. When you invest in a stock mutual fund, you are buying a share of multiple companies; this group of companies changes over time, depending on the fund manager. You are responsible for paying taxes on all distributions from the mutual fund, and these distributions are taxed at your level, not at the fund level. Mutual funds are generally delineated by investment objective and may include any of the asset classes discussed earlier.

Stocks are advantageous because they offer the highest potential return of any of the major asset classes. Growth stocks and value stocks tend to perform well in alternating cycles, so it makes sense to own some of both. Stocks are good for long-term investing: as mentioned earlier, this is the only major asset class that has consistently beaten inflation over the long term.

The disadvantages of stocks include that they offer less stability of principal than other asset classes, and they are subject to short-term price fluctuations. Because of these factors, stocks are very risky for short-term investments. If you are investing for less than five years, only invest a small portion of your money, if any, in stocks.

Stocks consistently yield the highest return of any asset class, but they also have the highest risk. Nevertheless, even though stocks can be volatile in the short-term, they continue to deliver returns that far surpass taxes and inflation over time. Through broad diversification, you can reduce some of the risks of this asset class and still receive the benefits of stock investment.