What Is a Blue Chip?
A blue-chip stock is that of a well-established company that is considered stable and which pays regular dividends. Typically, the term ‘blue chips’ refers to the constituents of the major stock indices. The word derives from the high value of blue casino chips.
Blue Chip Stock Characteristics
Blue-chip stocks are seen as less volatile investments than owning shares in companies without blue-chip status because blue chips have an institutional level in the economy. The stocks are highly liquid since they are frequently traded by individual and institutional investors alike. Therefore, investors who need cash on a whim can confidently create a sell order for their stock, knowing that there will always be a buyer on the other end of the transaction.
Blue-chip companies are also characterized as having little to no debt, large market capitalization, stable debt-to-equity ratio, and high return on equity (ROE) and return on assets (ROA). The solid balance sheet fundamentals coupled with high liquidity have earned all blue-chip stocks the investment-grade bond ratings. While dividend payments are unnecessary for a stock to be considered a blue-chip, most blue chips have long records of paying stable or rising dividends.
An investor can track the performance of blue-chip stocks through a blue-chip index, which can also be used as an industry or economic performance indicator. Most publicly traded blue-chip stocks are included in the Dow Jones Industrial Average (DJIA), one of the most popular blue-chip indices. Although changes made to the DJIA index are rare, an investor tracking blue chips should constantly monitor the DJIA to stay up to date with any changes made.5
Blue-Chip Stocks' Safety
While a blue-chip company may have survived several challenges and market cycles, leading to it being perceived as a safe investment, this may not always be the case. The bankruptcies of General Motors and Lehman Brothers and leading European banks during the global recession of 2008 are profs that even the best companies may struggle with during periods of extreme stress.6
While blue-chip stocks are appropriate for use as core holdings within a more extensive portfolio, they generally shouldn't be entire. A diversified portfolio usually contains some allocation to bonds and cash. Within a portfolio's allocation to stocks, an investor should consider owning mid-caps and small-caps as well.
Younger investors can generally tolerate the risk of having a more significant percentage of their portfolios in stocks, including blue chips. In comparison, older investors may choose to focus more on capital preservation through more effective investments in bonds and cash.
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