What is Growth Investing and How Does it Work?
Everyone has their own investment style and risk tolerance. However, if you want to find success in growing your assets in the stock market, you’re going to need to be comfortable with the diversification of your trading strategies as well as your assets.
While many people understand the importance of diversifying the ETFs or mutual funds as a way to guard against volatility, not as many people understand that there are two main strategies to consider when it comes to actively trading stocks on Wall Street.
While value investing is one of the most prominent investment strategies out there (thanks in part to its popularity with big-name investors like Warren Buffett), another option to consider is growth investing. Like value investing, growth investing aims to increase your cash flow thanks to a company’s share price increasing over time. However, while investing in value stocks involves using valuation techniques to find a company that is undervalued, investing in growth stocks involves finding companies whose past performance illustrates higher returns than anticipated.
Read on to learn more about growth investing, which is a valuable strategy to include in the diversification of any investment portfolio.
What is growth investing?
When it comes to investing in the stock market, you have course want the stock price of your investments to increase over time. Since that’s most people’s general understanding of the point of the stock market, it may seem like the concept of “growth investing” is a bit silly, since that should be everyone’s investment strategy. However, that’s missing the point.
If you’re looking to invest in growth stocks, you’ll need to look for companies who have a track record of profitability, often exceeding their goals to offer a high amount of capital appreciation. When it comes to identifying which stocks may qualify as growth stocks, you may look at companies whose prices are higher than other options or offer a history of strong performance even through economic downturns. While you may wind up paying a high price for growth stocks compared to penny stocks or other shares on the market, the hope is that the growth rate of that company ultimately makes you more money in the long run despite a steeper entry fee.
Getting started as a growth investor
When it comes to making money as a growth investor, you’ll want to make sure that you take a good hard look at a company’s performance and consider whether or not it has the potential to continue exceeding its earnings goals year over year. Small-cap companies, technology or healthcare businesses, and penny stocks (for the risky) all have the potential to grow in impressive ways, making them worth investing in.
One of the simplest ways to find companies that have the potential for impressive growth is to look to the Russell 3000 Growth Index. Since this index weighs 3,000 different companies based on their market capitalization, you can easily see which companies are outperforming others in terms of growth. Some of the top performers on the Russel 3000 Growth Index in 2020 included familiar tech companies like Amazon (AMZN), Apple (AAPL), Microsoft (MSFT), and Facebook (FB).
Another way to determine whether or not a company makes sense for your growth investment portfolio is to use something known as the price-to-earnings ratio to better evaluate how a company is doing.
Understanding the price-to-earnings ratio (P/E ratio)
Also known as the P/E ratio, the price-to-earnings ratio is a formula you can use to understand a company’s potential growth rate and how that earnings ratio can increase the value of your investment.
In order to effectively utilize the P/E ratio, you’ll need to divide the market value price of a company’s share by earnings per share (or EPS). The EPS of a company ultimately offers insights into how much profit a company would make by sharing all of its shares, which can be useful in determining its market value compared to the rest of the market.
For example, you could use the P/E ratio to compare any company’s values to another company’s, or even to a section of the stock market as a whole. By comparing Amazon’s (AMZN) P/E ratio of 77.69 in 2020 to the S&P 500’s current P/E of 39.78, you can see that Amazon is outperforming most companies in the S&P 500 by almost double.
In some situations, a particularly high P/E ratio could be the sign that a company is overvalued; however, if a high P/E ratio is consistent over several years—as is the case with Amazon—that could be a sign that the company represents the sorts of earnings ratio you’re looking for in order to truly capitalize on your earnings growth.
Like any form of investing, your brokerage may charge you certain fees for buying and selling growth stocks. It’s also worth noting that because many growth stocks are already top-performers, it may be expensive to invest in them without a hefty sum of money.
While penny stocks do offer the potential for big growth, they can also be even more volatile than other aspects of the market—and, as such, even more costly. If you’re looking to get started growth investing, penny stocks can be a great way to dip your toes in for a minimal investment; however, it’s worth noting that it’s as easy to lose big with penny stocks as it is to make significant gains.
Of course, as is the case with any investment strategy you might be considering, there are some benefits and drawbacks to consider before opting into a growth investment approach. Here are just a few of the pros and cons of growth investing:
- Can offer big returns. One of the biggest benefits of a growth investment strategy is the fact that it can earn you some serious money. When you consider that growth stocks consistently outperform value stocks and traditional interest rates if you have the money to get into growth investing it can really pay off.
- Pairs well with other strategies. It’s worth noting that you don’t need to go all-in on growth investing in order for it to make you money. As such, many investors choose to allocate a portion of their portfolio to growth investing, a portion to value investing, and a portion to much more stable investment vehicles like bonds. This allows you to diversify your portfolio without sacrificing some of the valuable earning potentials that comes with taking a risk on certain growth stocks.
- Expensive to get into. Cost is one of the biggest cons of growth investing, since many companies are already trading at high values. Buying one share of Amazon (AMZN) will cost you over $3,000 at the time of this writing. While that money is likely to offer a nice return over the next few years, that kind of cost can be prohibitive to investors just starting out.
- Bubbles and volatility. Perhaps more than any other type of investment, growth stocks are more likely to swing in price wildly and run the risk of winding up in bubbles. While a bubble could be good news for you if you got in early, it can be difficult to read through the noise and make an informed decision if you’re not confident in a company’s potential for growth. As such, growth investing isn’t for the faint of heart and should only be a portion of your investment strategy.
The bottom line
While growth investing does involve some risk, the same can be said for any other form of investing, too. As such, it’s worth considering the pros and cons of allocating at least a portion of your stock portfolio to a few growth stocks. Over the past ten years, growth stocks have steadily outpaced most value investments, meaning that if you have the money to pay for some of the top contenders, you’re likely to make a nice return on your investment. At the very least, it’s worth having at least a few growth stocks in your portfolio for the sake of diversification.
That being said, every investor needs to think about their own personal risk tolerance before investing in any securities. The stock market can be a volatile place, and it’s important not to overleverage your existing savings in an attempt to get rich off of Wall Street.
More important than picking an investment strategy, it’s crucial to just get started investing. As you begin to build up your assets and become more familiar with investing in the stock market, you’ll be able to learn more about different strategies and determine whether or not they make sense for you and your goals. Ultimately, if you have a significant amount of money to invest or particular goals in mind with your portfolio, it may be worth talking to a financial advisor in order to help you get started generating and managing your wealth.