Stock investing is an important engine of growth in your portfolio, but deciding on an investing strategy and particular stocks can be challenging. When creating a diversified portfolio that is designed to reduce risk, it can help to think of stocks as falling into one of two categories: growth stocks and value stocks.
Both growth and value stocks can be important components of your portfolio, but they carry different forms of risk and require different investing approaches.
Growth investing requires seeking out companies with strong earnings growth and the potential to outperform the overall market. These stocks typically represent companies with a history of above-average gains and an expectation of continuing to deliver high levels of profit growth.
When choosing growth stocks, investors may look for companies that are leaders in their industry or have a good chance of considerable expansion over the next few years. Companies with new products that are expected to sell well or that are creating new and transformative technology are often considered growth companies.
Growth stocks are usually priced higher than the broader market because investors are willing to bet on their potential for continued earnings growth. The advantages of growth investing include the potential to sell the stock at a much higher price if the company continues to grow. On the other hand, the big risk of this style is that growth expectations may not be met, causing prices to fall sharply. Growth stocks are less likely to pay dividends to shareholders, preferring instead to reinvest profits in the company itself.
Value investors take a different approach, seeking out companies that appear to be undervalued in the marketplace relative to their fundamental measures, such as sales or earnings. A value investment might include a company with good financials, but poor public perception or a newer company that investors haven’t paid much attention to yet.
Investors hope to find companies trading at lower share prices than companies of similar value. They count on prices increasing as the market eventually recognizes the company’s fundamental value over time.
By definition, value stocks tend to be priced lower than both the broader market and similar companies in their industry, which may make them easier for more investors to afford. But a value stock investment may take longer to pay off, and there’s always the chance that the market has indeed priced the stock accurately, leaving little potential for gains. Value stocks are more likely to pay dividends.
Which one should you choose?
The styles of growth and value investing complement each other, and investing in growth stocks and value stocks is one way to add diversity to your portfolio. Some investors, however, favor one approach or the other. In that case, there are some factors to consider.
Growth stocks tend to be more volatile than value stocks, with more price fluctuations of greater magnitude. For this reason, growth stocks are inherently riskier than value stocks and may be better suited for risk-tolerant investors with a longer time horizon.
Value stocks tend to offer less growth potential in the short term, but could be less volatile, generally making this strategy a better fit for more risk-averse investors.
Choosing between these two strategies may also come down to economic conditions. Some experts say growth stocks tend to perform better when interest rates are falling and company profits are rising, and value stocks do better during an early economic recovery period.
It bears repeating that not all so-called growth stocks end up growing, and not all so-called value stocks deliver value. Once you’ve settled on an approach according to your personal preferences, investment timeline, risk tolerance, and financial goals, you still have to do research on the stocks themselves to decide whether you want them in your portfolio.
Diversification neither ensures a profit nor protects against a loss.