By: Kara Perez
Updated: June 11, 2019
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 are and how you can smartly invest in them.
What Is a Growth Stock?
A growth stock is stock in a company that is performing high above the 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
Sounds like the perfect investment, right? Who doesn’t want something that is growing quickly and bringing in the big bucks in their stock portfolio?
What Are the Drawbacks of Growth Stocks?
Here’s the fine print on growth stocks. Growth stock companies generally do not pay dividends, because the companies are primarily reinvesting their earnings into new or better products. They’re trying to maintain a clear advantage in the market, so they take their money and use it to fuel their growth.
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.
How Does a Growth Stock Differ From a Value Stock or an Index Fund?
The most direct comparison to growth stocks can be made with value stocks. Value stocks are stocks that trade at a lower value than their competitors, and they pay dividends. The idea behind being a value stock investor is to purchase a valuable stock while its shares are priced low so that as the stock grows in value, your dividends and overall value of stock grow.
Growth stocks differ from index funds in a few key ways as well. First, 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.
Where Can I Find Growth Stocks?
As we mentioned above, you may find growth stocks in an index or mutual fund. Beyond that, you’ll have to identify which stocks are growth stocks with financial magazines like The Wall Street Journal or Barron’s Magazine. You can also consult with investing companies such as Zackstrade or Fisher Investments.
Before you purchase any growth stocks, you’ll have to determine what qualifies as a growth stock to you. Keep these criteria in mind as you start your research:
- Strong market performance in the last few years
- Continued or accelerated production and output
- Clear identity in its respective arena
From there, you will begin to build a list of growth stocks that you might be interested in buying. Make sure to really do your research! Listen to what experts have to say, but make sure your purchases are in alignment with your own financial plan.
Ask Yourself These Questions Before Investing
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 on 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?If nothing else, it’s a truth to investing that the 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.
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.