We all want to know how to invest smartly. But how? One way to look at investing is to compare the known versus the unknown. Here’s what I mean. Years ago, my wife and I went to a home and garden show. A vendor that was selling carpet cleaning products caught our attention.
We had never heard of the company that made the carpet cleaner this guy was selling, but his product was amazing. It was a white powder you sprinkled on a carpet stain. After applying the powder, you moistened it by spraying only water. After a quick scrub, the stain and the powder disappeared. With two kids and a dog, we needed a reliable carpet stain remover. Even though it was more expensive than more recognizable stain removers, we bought a container of the product.
When we got home, we were anxious to try the stain remover. We used it just as it was demonstrated. Guess what? It didn’t work! It was horrid. Not only did it not work, it also made the carpet smell like dead fish! So now we had an expensive bucket of dead fish-smelling powder and a smelly carpet stain. To make matters worse, we did not buy it someplace we could return it. After that, I had to rent a carpet cleaning machine to clean the smelly carpet.
So how does this relate to investing? It comes down to the recognizable versus the unknown. Sometimes buying something you’ve never heard of works, and sometimes it doesn’t. In situations where you need dependability, the known should trump the unknown.
Today’s post will briefly examine how this concept applies to stocks.
What are Recognizable and Unknown Stocks, and How Do They Differ?
Recognizable and unknown stocks are terms used to describe the type of stocks an investor may choose to invest in. Let’s expand that concept.
Recognizable stocks
Recognizable stocks are stocks of well-established, publicly traded companies that are well-known to the public and have a proven track record of success. These companies are sometimes referred to as blue-chip. A business reporter coined the name blue-chip in the 1920s. He compared high-value stocks to high-dollar blue poker chips that were popular in the casinos of the 1920s. Examples of recognizable stocks include blue-chip companies like Apple, Amazon, and Coca-Cola. What we are referring to as recognizable or blue-chip stocks today are typically large companies with a high overall company value. For example, Apple is known as the first trillion-dollar company.
When you hear experienced investors talk, it might seem like they have their own language. For example, the terms large cap or small cap refer to a company’s size. You’ll find that there are standard dollar parameters to define large or small caps, but those are beyond what we’re going to talk about today.
Unknown stocks
On the other hand, unknown stocks are stocks of smaller, less well-known companies with different brand recognition or stability than recognizable stocks. These companies may be in the early stages of growth, have a lower market capitalization, and be less established in their respective industries. Examples of unknown stocks may include startups, small-cap companies, or companies that are not well-known to the public.
The difference between recognizable and unknown stocks can significantly impact an investor’s portfolio. Recognizable stocks tend to be more stable. Yet depending on economic conditions, they can still have wide swings in valuation. On the other hand, unknown stocks may offer more significant growth potential but may also carry even higher risks. By the same token, it’s essential for investors to carefully consider their individual investment goals, risk tolerance, and financial situation before choosing between recognizable and unknown stocks.
Advantages of Investing in Recognizable Stocks
Recognizable stocks are typically well-known blue-chip companies that have been around for a long time and have a strong track record. In addition, some blue-chip companies pay earnings directly to shareholders through stock dividends. Paying earnings to stockholders makes them attractive investments for income and capital appreciation.
But not all recognizable companies pay dividends. Overall, how a company pays its dividends is a choice made by its board of directors. Some companies are more inclined to allow their earnings to grow the value of their stock. And some companies choose to pay those earnings to shareholders through dividends.
Because of the sheer number of recognizable stocks, investors can have a diversified portfolio of only recognizable stocks. There are many different business models and industries to diversify within.
How I Look at Recognizable Stocks and Unknown Stocks
I use the acronym SEC when I am analyzing stocks. It stands for stability, earnings, and competitiveness. It is a strategy that works well with all stocks; this is how I apply it to recognizable or blue-chip stocks.
1) Stability
Recognizable stocks tend to be more stable and have a wide moat. I am referring to a characteristic that famed investor Warren Buffett has popularized when referring to the stability of a company. Mr. Buffett says, “What we are trying to find is a business with a wide and long-lasting moat around it protecting a terrific economic castle with an honest lord in charge of the castle.”
2) Earnings
Earnings are the profits that a company has from its operations. You will find its earnings if you research a company’s financial performance. Most blue-chip companies have stable or growing earnings. An example is companies that are on the dividend aristocrat index. To be on this index, a company must have raised its dividends consistently for at least the past 25 years and have a market capitalization of over $3 billion.
3) Competitiveness
Recognizable stocks are often from well-established companies with a proven track record of success. How their track record compares to their peers is often a sign of their dependability. Superior competitiveness can provide a level of comfort for some investors. Yet it is critical to realize that a company’s past performance is NOT A GUARANTEE of its future results.
It’s important to note that while investing in recognizable stocks can provide several advantages, investors should thoroughly research the company and its financials before investing to ensure that the stock is a good fit for their investment goals and risk tolerance. By their nature, all stocks have risks and the potential for losing value.
Risks of Investing in Recognizable Stocks
While investing in recognizable stocks can offer several advantages, there are also risks. Some of the dangers of investing in recognizable stocks include the following:
Overvaluation
Recognizable stocks may become overvalued, mainly if they are heavily traded or widely held. The overall market of stocks can influence overvaluation as well. Overvaluation can make a stock’s price swing wildly.
A good measure of a stock’s valuation is the price-to-earnings ratio. Generally speaking, a stock with a price-to-earnings ratio higher than the market index average is considered a growth stock. It is regarded as a value stock if it has a PE ratio below the market index average.
Economic and market risks
Recognizable stocks, like all stocks, are subject to economic and market risks. Economic downturns, recessions, or market corrections can significantly impact the stock’s value, leading to potential losses for investors.
Dependence on a few key products or services
Some recognizable stocks may depend heavily on a few key products or services for their success. If these products, services, or supply chains experience a downturn, it can significantly impact the stock’s value.
Take for example, Align Technology, one of the largest NASDAQ index stocks. They have one product line, the Invisalign dental system used by orthodontists. Granted, as of this date, they have over 12 million customers. But they have a limited variety of products.
Competition
Recognizable stocks are often leaders in their respective industries but may also face competition from new or existing competitors. In fact, not being able to compete well can negatively impact the stock’s value if the company cannot compete effectively.
Lack of growth potential
Recognizable stocks are often well-established companies that may have already reached their peak growth potential. Market saturation can limit the potential for future growth and returns for investors.
Slower growth
Recognizable stocks may grow more slowly than unknown stocks, as they are often larger and more established companies that may have already reached a significant portion of their growth potential.
The Benefits & Risks of Investing in Unknown Stocks
Investing in unknown stocks can be a risky venture as well. Being that as it may, unknown stocks can also be a great way to make speculative investments and capitalize on innovative opportunities. But suppose you want to invest in unknown stocks. In that case, you have to accept that they may be volatile, have unknown results, or even declare bankruptcy. Small-cap stocks are often the most attractive option for investing in unknown stocks as they tend to have higher potential returns than large-cap stocks. However, this also means that investors must be prepared to take on more risk when investing in these stocks. In the long run understanding the benefits and risks of investing in unknown stocks are essential before taking the plunge into this type of investment.
Sometimes neither is suitable.
Sometimes neither well-known stocks nor less well-known stocks are suitable for investing. At times, your goals, risk tolerance, and investment horizon heavily influence the decision not to invest.
Here are a few considerations to help you make an informed investment decision:
Risk tolerance
Regardless of recognizable vs. unknown, your ability to tolerate risk should guide you in your investment selection. Risk tolerance is not only how you feel about the risk of an investment. Risk tolerance should consider the effect losses will have on your financial health. Budgeting is one of the best ways to determine how much risk you take. If you want a tool to help you determine how much you could put at risk for investing, try this: The Easiest Retirement Budget Worksheet
There may be times when you want to avoid taking any risks. Or there may be times when you want to split your assets between accounts between risk and guaranteed. With this in mind, I created an assessment quiz to determine your risk comfort level. If you’d like to try it, you can download it here.
Investment goals
Investment goals should heavily influence your decisions. Let’s say, for example, that you want to buy a house and are saving for a downpayment. Investing in the short term can be a gamble you want to avoid taking. One of the worst reasons to invest is because you are trying to make up shortfalls in income or losses. It’s like a casino game where you gamble double-or-nothing. Nothing is highly possible. For short-term goals, always pick an account with a guaranteed principle.
Investment horizon
If you have a long-term investment horizon, both recognizable and unknown stocks can be an appropriate vehicles if you accept the risk. As I said in discussing investment goals, investing in the short term can be a gamble you want to avoid taking.
Investment goals that are further off give you time to take advantage of economic cycles. Here’s what I mean. Generally speaking, when investment markets tend to move down, those cycles last between twelve and eighteen months. That’s what investors call a bear market.
When markets are in a rising cycle or bull market, they tend to last longer. On average, bull markets last about five years, although some have lasted significantly longer while others have been shorter.
If you want to take advantage of market cycles, you should invest for at least three to five years. More extended periods have a lower probability of losses.
Diversification
There are two ways to look at diversification. One way is the Warren Buffett approach. Buffett wrote in his 1993 letter to Berkshire Hathaway shareholders: “diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.” So if you have the investment savvy of Warren Buffett, by all means, don’t diversify. But if you’re like most people, diversification is your friend.
Most people should consider using the investment concept Harry Markowitz created, the Modern Portfolio Theory. The theory suggests that by diversifying investments across a range of assets, such as stocks, bonds, and real estate, an investor can reduce the overall risk of their portfolio while still achieving the desired level of return.
Research
Before investing in any stock, it’s essential to thoroughly research the company, its financials, and the industry and market conditions. Research is critical for small-cap stocks because the stocks are less frequently traded, and information on those stocks usually is less prevalent than with large-cap blue chip stocks. As I have noted, begin by reading about a stock’s stability, earnings, and competitiveness. Those characteristics will give you a good starting point for finding investments you like.
Conclusion: How to Make the Best Investment Decision for Your Financial Goals & Risk Tolerance
Making the best investment decision for your financial goals and risk tolerance requires careful consideration of several key factors:
- Define your financial goals.
- Assess your risk tolerance.
- Consider your portfolio diversification.
- Do your research.
- Seek professional advice.
If you need help making the best investment decision for your financial goals and risk tolerance, consider finding a good fiduciary advisor. They can help you create a customized investment plan tailored to your needs and goals.
Making the best investment decision can be a daunting task. However, having the proper guidelines and guardrails in place will help you make decisions, ensure you get the most out of what you have, and stay on track.
Part of the planning process should include a personal investment policy that outlines how you will allocate capital, distribute income, and guide your risk comfort level. An investment policy helps to ensure that all decisions are in your best interest in mind.
As always, to end today, remember that this information is for educational purposes only. This information is not investment, accounting, or tax advice. For those things, you need to find yourself a good fiduciary advisor. 😉
Have a great week,
Van
PS, here are some other great topics from my blog that may interest you.
Being An Accidental Retiree
Does Asset Allocation Still Work In 2023?
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