Investing in growth stocks can be a great way to increase your wealth over the long term. But this strategy also comes with greater risks than investing in more stable securities. Let's take a look at what growth stocks, how they are compared to value stocks are and how you can smartly invest in them.
In this Guide:
What Is a Growth Stock?
A growth stock is a stock in a company that is performing high above average industry returns. The company is growing rapidly, and its cash flow, revenue, and earnings are expected to outpace the competition. Usually, the company has some sort of lock on a market, whether that be radical innovation or a strong patent on an in-demand product.
Not all growing companies qualify as growth stocks. While there is no one formula to determine what qualifies as a growth stock, there are general terms. Growth stock companies are generally expected to:
- Grow at 15% or more return on equity annually
- Have shown a strong stock performance historically
- Have strong profit margins
Where Can I Find Growth Stocks?
- Growth stocks can be found in an index or mutual fund. Ally Invest, for example, is a great broker to manage your mutual funds portfolio.
- You can also consult with investing companies such as Zacks Trade or Fisher Investments.
- Beyond that, you'll have to identify which stocks are growth stocks with a financial magazine like The Wall Street Journal.
- Strong market performance in the last few years
- Continued or accelerated production and output
- Clear identity in its respective arena
Pros & Cons of Investing in Growth Stocks
Before you adopt a growth investing strategy, it's important to review the advantages and disadvantages to determine how growth assets could work in your portfolio.
- Potential to grow at a faster rate. Successful growth assets have the potential to appreciate at a rate that beats the overall market.
- High earnings growth. Better earnings growth could be possible even during times of economic slowing. Even if the companies are impacted, they could still perform better than other assets.
- Chance to invest in emerging assets or companies. You have an opportunity to be a part of something exciting, especially if you focus on emerging growth investments.
- Potential for more volatility than other investments. Sometimes growth assets have wider price swings than other assets. With the potential for greater and faster growth also comes the potential for bigger losses.
- Higher prices relative to the market. When you invest in growth assets, you could end up paying a premium. Prices are often higher, and you have to hope that future gains will be worth the higher current price.
- You might not receive dividends. Rather than paying dividends to their shareholders, many growth companies instead reinvest their earnings in growing the company. This can mean better appreciation later, but it also means you don't receive income from your shares.
This means that investors don't make money from dividend payments, but rather only from the sale of the stock. Timing when that sale should happen is a tricky process. Sell too early and you'll lose money on future growth. Sell too late and you'll lose money due to declining profits. And don't forget, no matter when you sell your stock, you have to pay capital gains tax.
Further Reading: What is GARP Investing
What Is Value Investing?
Value investing, on the other hand, is about trying to identify assets that are undervalued by the market. The idea is to find assets that offer a good bargain. Maybe the company is experiencing a temporary setback, but the fundamentals are still strong. Or perhaps it's a relatively new stock that hasn't been widely recognized as valuable yet.
No matter how it's done, value investing is about looking at assets and investing in those that are priced lower than they should be. You invest in them with the hope that they will head higher later as others recognize their value.
Pros & Cons of Investing in Value Stocks
Value investing seems like the best approach, especially for those who are a little more risk-averse. But remember that there are different types of risks. And the tradeoffs made with value investing can also impact your portfolio.
- It's possible to find good deals. Value investing is about finding good deals. You can spend a small amount of money on a stock and potentially see a bigger return down the road.
- Risks can be somewhat lower. There isn't usually as much volatility with some value assets, because they are already lower. And there may not be as much room for big swings.
- Potential for consistent gains. Rather than seeing big gains, you have the potential to see steady gains over time. Many long-term and buy-and-hold investors like to take a value-based approach.
- You could lose out on big wins. Value investors run the risk of missing out on larger returns. Whenever you focus on a margin of safety to reduce your overall volatility risk, you wind up potentially missing out on big returns.
- Value assets don't always return to profitability. Even if something seems like a good deal, it can still be problematic. It's hard to tell when a stock has bottomed out, so it could fall farther. On top of that, you might buy an asset you feel is undervalued only to be stuck when it never sees its potential profits.
- There's a lot of time involved. Looking for the “right” value stocks can take a lot of time and energy. You might put a lot of effort into your research — only to be wrong.
Growth vs. Value Investing — Which Is Better?
One of the most important things to consider when deciding between growth vs. value investing is that one approach is not inherently better than the other. What you choose depends on your own style, as well as the goals you have for your portfolio.
- Growth investing is for quicker results– If you hope to amass a larger portfolio in a shorter period of time and see quicker results, a growth approach can work well.
- Value Investing is for consistent returns — If you have a long period of time to grow your wealth and beating the market isn't one of your major objectives, value investing can be an excellent way to see consistent returns over the long haul.
You Can Switch Styles as Life Goes On — Realize that as your portfolio grows and you reach different life milestones, it may be appropriate to switch styles. You don't have to stick with one approach or the other forever. Instead, you can shift strategies over time. Later on, you may decide that neither growth nor value investing is right for you. Other investing strategies, like income investing, may make sense as you approach retirement or as your goals change.
Combining Growth and Value Investing
it's important to note that you don't have to choose between growth vs. value investing. It's possible to incorporate both into your portfolio. You could include some growth assets to help accelerate your portfolio's growth while still keeping a portion of your portfolio in value assets.
When you use both approaches in your portfolio, you can offset some of the disadvantages of each type of investing. For example, if market volatility is hitting your growth assets, some of your value assets could hold steady and reduce the overall risk of your portfolio during this time.
Additionally, if you're afraid the value approach won't allow you to build your portfolio quickly enough, adding growth assets can help you accumulate more earnings. When used together, growth and value investing can provide a complementary portfolio construction.
It's possible to use growth and value asset allocation to meet your goals and shift your allocation as your needs and objectives change over time.
Growth Stocks vs Index Funds
Growth stock purchases are individual stock purchases. When you buy an index fund, you're buying into every company in the index, which means your purchase is automatically diversified. You now own small parts of all the companies in the index rather than a large amount of one company.
With growth stocks, you aren't buying an index. You're buying only one company. If that company does well, you'll reap more of a reward than if you owned an index–fund–sized share. If that company doesn't do well, you can lose more than if you owned an index fund.
Index funds may be a combination of growth and value stocks, which appeals to some people. Rather than having to choose one type of investment style with your money, you could potentially buy into an index that already has both in it.
Ask Yourself These Questions Before Investing in Growth Stocks
Here are a few questions to ask yourself before you make any growth stock purchases.
- How does this play into my overall investment portfolio? Will growth stocks be the predominant part of your portfolio? Are they going to tie into other stock market investments or investments outside the market?
- What is my timeline for holding this stock? Do you plan to hold this as long as you can, or are you looking to get in and get out relatively quickly? What amount of time are you willing to give the company to produce results for you?
- How much volatility am I comfortable with? The stock market will go up and down over time. How much loss are you comfortable accepting, and how long will you endure a down stock until you want to cut loose?
- How much can I — or do I want to — invest in growth stocks? Will the money you use for growth stocks be in addition to or instead of any other investing you do? Will you invest in these stocks after you contribute to your retirement accounts at the same time, or before any retirement savings?
Answering these questions before you buy anything will give you a good idea of what you're stepping into and how you want to handle it. Combining thorough research with a clear personal investing plan should yield a plan that makes sense for your financial future.
Investing in Your Future
Growth stocks offer a chance for people to invest in individual stocks and round out their portfolios. They can offer a chance at a very profitable stock sale. However, keep in mind that most of them don't pay dividends, and there's always the risk that you'll buy into a stock that you can't sell for more down the road, meaning that you never really make any money with them.