Growth stocks: what they are and why you should care

Growth stocks vs. value stocks

When we talk about stock investing, there are two prominent approaches: growth investing and value investing. And while we've already discussed how growth stocks represent companies with strong potential for rapid expansion, value stocks take a different approach. These are shares of companies that the market has undervalued.

Value stocks typically belong to more established companies that might be temporarily overlooked by the market, offering an opportunity for investors who believe the stock is worth more than its current price. This approach contrasts with the forward-looking nature of growth stocks, as value investing focuses on finding bargains in the current market environment.

Key differences between growth stocks and value stocks

• Valuation. Growth stocks often trade at higher price-to-earnings (P/E) ratios due to their potential for future growth, whereas value stocks are usually priced lower relative to their earnings, reflecting a market discount.
• Dividends. While growth stocks typically reinvest earnings to generate further growth, value stocks often pay higher dividends, providing a regular income stream to investors.
• Risk and volatility. Growth stocks are generally more volatile and sensitive to market sentiment, while value stocks offer more stability since their prices are mainly based on current fundamentals.
• Investment focus. Growth investors seek significant capital appreciation, and, as a result, they are willing to accept higher risks. In contrast, value investors aim to buy stocks at a discount, looking for safer investments with a potential for price correction.
• Market conditions. Growth stocks tend to perform well in bullish markets, where optimism drives prices up. Value stocks, on the other hand, may offer more resilience in bearish markets, as their prices are already lower and less susceptible to further declines.

Once you understand these differences, you can better decide which approach aligns with your financial goals and risk tolerance, or whether a combination of both might be the ideal strategy. But first, let us return to growth stocks and see why they can be appealing to some investors.

Why invest in growth stocks?

Growth stocks can offer opportunities for investors looking to maximise their returns over the long term.

Here are a few key reasons why you should consider investing in growth stocks:

Potential for high returns

Growth stocks are known for their ability to deliver substantial capital appreciation. As these companies innovate and capture more market share, their stock prices can rise dramatically, offering investors the chance to multiply their initial investments.

Benefiting from innovation and market disruption

Many growth companies are at the forefront of their industries, driving change through innovation, whether through cutting-edge technology, healthcare breakthroughs, or disruptive consumer products. Investing in growth stocks allows you to tap into this innovation, potentially benefiting from the next big trend or market shift.

Compounding growth over time

One of the most powerful aspects of growth investing is the potential for compounding. As these companies reinvest their profits to fuel further expansion, the value of your investment can grow exponentially over time. This makes growth stocks particularly attractive for long-term investors who are patient enough to ride out market fluctuations.

Diversification benefits

Including growth stocks in your portfolio can provide diversification benefits. While they may be more volatile, their potential for outsized gains can complement more stable investments like bonds or value stocks. This balance can help smooth out overall portfolio performance, especially during periods of economic expansion.

Participating in economic growth

Investing in growth stocks also means participating in the broader economic growth. As these companies succeed, they contribute to the overall economy, creating jobs, driving innovation, and enhancing consumer choice. By investing in growth stocks, you align your financial interests with these broader economic trends.

Risks of investing in growth stocks

While growth stocks offer the potential for significant returns, they also come with risks that investors need to be aware of. Here are the six main risks of investing in growth stocks:

1. Increased volatility

Growth stocks are often more volatile than other types of investments. Their prices can fluctuate widely based on market sentiment, economic conditions, or changes in investor expectations. This volatility means that while the potential for high returns is there, the potential for losses is equally present, especially in the short term.

2. High valuations

Growth stocks typically trade at higher price-to-earnings (P/E) ratios, reflecting the market's optimism about their future prospects. However, these high valuations can be a double-edged sword. If a company fails to meet growth expectations, its stock price can drop sharply, leading to significant losses for investors.

3. Lack of dividends

Most growth companies reinvest their earnings into the business rather than paying dividends. While this can fuel further growth, it also means that investors do not receive regular income from dividends. The lack of dividends makes growth stocks less appealing to those seeking steady cash flow from their investments.

4. Economic sensitivity

Growth stocks are often more sensitive to changes in the economic environment. During economic downturns or periods of market uncertainty, these stocks can be hit harder than more conservative investments, as investors tend to turn to safer, more stable assets.

5. Company-specific risks

Growth companies are often in the early stages of their development, meaning they may face higher operational risks. These can include challenges like competition, management effectiveness, regulatory hurdles, or changes in consumer behaviour. If a growth company fails to overcome these challenges, it can lead to disappointing performance and a decline in stock value.

6. Overexposure to specific sectors

Many growth stocks are concentrated in particular sectors, like technology or healthcare. While these sectors may offer growth opportunities, they can expose investors to sector-specific risks. If an entire industry faces challenges, it will naturally negatively impact all the stocks within that sector, including your growth investments.

Conclusion: Balancing high potential with risk

Growth stocks give investors like you the chance to be part of some of the most innovative and fast-moving industries, from technology to healthcare. The potential for high returns is there, but always remember that they come with their own set of risks.

Volatility, high valuations, and sensitivity to economic changes are all factors to consider. But if you are comfortable accepting these risks, these stocks can potentially offer substantial rewards, especially over the long term.

In fact, both beginners and experienced investors can gain a lot from incorporating growth stocks into their broader investment strategy, provided they’re prepared for the unique challenges that come with these high-growth opportunities.