If you’ve ever played poker, you might already be familiar with the term “blue chip.”. On a traditional set of poker chips, blue chips signify the highest value — usually around $25 per chip. Similarly, a blue chip stock is a stock tied to a large, respected, and stable corporation.
Blue chip stocks tend to perform well in both bull and bear markets. They are generally considered to be leaders in their respected industry. Blue chip stocks also tend to be less volatile than other types of stocks. This means you have less of a chance of losing all of your money when you invest in them.
Today, we’ll learn a little more about what makes a stock a blue chip. In addition, we’ll review some of the pros and cons of investing in blue chip stocks.
How Does a Company Get a “Blue Chip” Designation?
Blue chip stocks are stocks that have a proven track record of reliable management, consistent dividends, and regular stock price increases. Some of the characteristics a stock must have before it can be considered a blue chip include:
Large Market Capitalization
Blue chip companies are industry leaders, with some type of competitive advantage that makes a complete corporate collapse very unlikely. As a general rule, most blue chip stocks have total market valuations of $10 billion and above.
A Solid History Of Growth And Increases In Stock Value
A steady history of growth is a hallmark characteristic of almost every blue chip stock. A blue chip stock might not see a sudden, massive increase in value (as we’ve seen with many tech stocks). However, when you look at a yearly growth timeline, you should be able to see the stock’s value rise over time.
Regular & Increasing Dividends
A dividend is a portion of a company’s profits that is paid out to investors on a regular schedule. Most corporations aren’t required to pay out dividends. However, most blue chip stocks offer regular, increasing dividends on a quarterly or monthly schedule. This is because blue chip companies often don’t need to reinvest as much capital into new business ventures.
Part Of A Major Index
An index is a hypothetical, weighted collection of stocks that compares current price levels to past market performance. Some of the largest and most important indexes include the S&P 500 and the Dow Jones Industrial Average, which intend to track the health and performance of the American economy as a whole. If a stock is included in any major index, chances are that it’s a blue chip.
Most blue chip stocks produce products that are household names. Some examples of blue chip companies whose products you might have in your house include:
- Johnson & Johnson
Are Blue Chip Stocks Safe?
When it comes to investing in the stock market, it’s important to remember that there are no guarantees or promises of return. A penny stock might soar in value overnight, while a blue chip stock’s value might reduce to a mere fraction of what it was once worth. However, blue chip stocks are widely considered to be some of the safest investments you can make. These companies have proven track records of proper marketing, business practices, and cash-flow management. They often have rock-solid financials, and they manage debt very well when they do require credit assistance.
While any blue chip stock is a solid investment choice, you should never put all of your eggs in one basket. Diversify your portfolio between a few different sectors by investing in a variety of blue chip stocks that produce varying goods and services.
You might also want to avoid investing directly in blue chip stocks and instead purchase a large-cap exchange traded fund (ETF). An ETF is sort of like a collection of stocks all bundled together within a specific ratio determined by the fund manager. You can buy and sell ETFs as shares — just like when you buy and sell individual shares of stock. Buying a major ETF is an easy way to diversify your portfolio and invest in a few different sectors at once. For example, when you purchase a share of the Vanguard S&P 500 ETF, you gain a small portion of ownership in Amazon, Verizon, Facebook, Alphabet (Google’s parent company), Microsoft, Berkshire Hathaway and many more blue chip stocks.
Benefits Of Blue Chip Stocks
Investing in blue chip stocks comes along with a number of benefits, including:
Blue chip stocks have proven track records on the market. Short of a major world war or an international financial crisis, blue chip stocks aren’t likely to dramatically shift in value. If you’re looking to start investing in the stock market but you’re terrified of losing all of your money in a recession, investing in blue chips is a great place to start.
Well-Regulated And Governed
Blue chip stocks have multiple layers of oversight, beginning with the SEC and ending in the company’s own elected board of directors. Blue chip corporations understand that they have a larger number of shareholders and investors to answer to and are less likely to be caught in price manipulation or deceptive marketing practices.
More Steady Income Over Time
If you’re looking to invest in the long-term (for example, to fund a retirement or a child’s college education) you can set yourself up for success by investing primarily in blue chip companies. These stocks have long histories on the market, and provide slow, gradual returns on investments.
Regular Dividend Payments
There’s no law that says that a blue chip stock (or any stock that isn’t operating as a REIT) must pay out a dividend to investors. However, most blue chip stocks keep regular dividend record and payment dates, offering dividends on a set and predictable schedule. If you’re looking to create a stream of passive income, you’re typically better off investing in blue chip companies.
A Better Understanding Of What You’re Investing In
When you start shopping for investments to add to your portfolio, you might notice that there are thousands of tiny tech, pharmaceutical, and start-up companies vying for your funding. But what exactly separates Capricor Therapeutics from the Fluidigm Corporation? How does the business model of Blink Charging differentiate itself from Plug Power?
Beginner investors often find it easier to begin by investing in blue chip stocks. This is because blue chip stocks have business models and products that they already understand. Most people have been to a McDonald’s restaurant, sipped on a Starbucks latte, swiped an American Express card, and surfed the web on an iPhone. When you invest in these stocks, you’re investing in a company whose product you know and understand. You are not investing in a nebulous concept that may or may not come to fruition.
Disadvantages of Blue Chip Stocks
Blue chip stocks are great — but they aren’t free of drawbacks. Let’s take a look at some of the disadvantages that you should keep in mind when you invest in blue chip stocks.
Blue chips’ low level of volatility can be a major asset during an economic downturn. It can be a drawback in times of booming economic activity. Blue chip stocks tend to increase in value slowly over time, and they rarely see major price fluctuations.
A Higher Financial Barrier Of Entry
One of the biggest drawbacks of purchasing a blue chip stock is that you’ll typically need a much larger capital investment to purchase a single share. For example, the current share price of Microsoft is about $230 a share, and you’ll need at least $3,200 to invest in a single share of Amazon stock. If you want to build a reliable stream of passive income, you’ll typically need hundreds of thousands of dollars to invest.
Poorer Dividend Yields
A stock’s dividend yield is a ratio calculation that tells you how much money you’ll receive in an annual dividend in comparison to what you had to spend as an initial investment to purchase the share. You can calculate a stock’s dividend yield by dividing the total annual dividend over the current share price. For example, if a share of Company X costs $20 and the company pays out $1 in dividends for each share per year, Company X has a dividend yield of 0.05, or 5%.
While extremely high yields are often a cause for concern, blue chip companies usually have very low dividend yield. This indicates that you’ll need to hold onto the stock for a much longer period of time to earn back the money you spent. For example, Microsoft’s current dividend yield is 1.43%, while Apple hovers around 1.36%. If you’re looking for a fast way to earn your money back through dividends, blue chips aren’t the answer.
Can Be Slower To Adapt
Blue chip companies have proven financial track records and business models. In some cases, larger companies may be more conservative in investing in new technology. That failure to adapt may cause the company to lose its blue chip status or even go bankrupt.
For example, Nokia was formerly considered a blue chip stock before the invention of the smartphone. After the U.S. housing market bubble burst in 2008, Lehman Brothers (once the fourth largest bank in the country) was forced to file for bankruptcy due to the company’s continued reliance on subprime mortgage lending.
The bottom line? Though blue chip stocks are a safer-than-average investment, there is no guarantee that they’ll only increase in value.
Creating the Perfect Portfolio
Blue chip stocks are shares of companies that have proven themselves on the financial market. They show low levels of volatility, show steady price increases over time, and represent major portions of their respective sectors.
Blue chips are solid and safe choices for long-term investing. However, these companies also don’t often drastically increase in value and may be cost prohibitive to new investors. They also generally have lower dividend yields. This means you’ll need to hang onto them for a longer period of time in order to recoup your investment.