What are growth stocks—and how do they differ from momentum stocks
Growth investing focuses on trying to identify and buy rising stocks when they have further growth ahead.
These stocks may trade at higher-than-average multiples of earnings, cash flow, book value and so on. Ideally, though, they also have above-average growth prospects, compared to alternative investments.
What are growth stocks?
By definition, growth stocks are companies that have above-average growth prospects. They are firms whose earnings growth has been above the market average, and is likely to remain above average. It is also often the case that they pay small dividends or none at all. Instead, they re-invest their cash flow in the business, to promote their growth.
Although these stocks can be highly volatile, they often make good long-term investments. They may be well-known stars or quiet gems, but they do share one common attribute—they have grown at higher-than-average rates within their industries, or within the market as a whole, for years or decades.
Don’t confuse momentum stocks for growth stocks
It’s all too easy to confuse growth stocks with momentum stocks. Momentum investors focus on growth stocks, but they want to hold only while prices are rising. They don’t mind paying a high price, because they plan to sell as soon as the rise begins to falter.
Momentum investors are particularly keen on the so-called “positive earnings surprise.” That’s when a company outdoes brokers’ earnings estimates.
Momentum investors see a “negative earnings surprise” (or lower-than-expected earnings) as a sell signal. They use a number of formulas to make buy and sell decisions, but all come down to “buy on strength and sell on weakness.” So they tend to pile into the same stocks all at once, and the gains that follow are something of a self-fulfilling prophecy.
The trouble is that when the stock’s rise falters, momentum investors also try to get out as a group, but there are never enough buyers. That leads to violent fluctuations in the stock’s price.
10 Stocks to Buy and Hold Forever
If you have six or seven of these stocks in your portfolio, good for you. These are stocks with staying power. They’ll hold their value through market setbacks—they all pay dividends, for one thing—and they’re first to move up when the market recovers.
Investors can minimize their risk in aggressive growth stocks by following these simple tips:
Limit aggressive investment holdings to 30% of your overall portfolio.
Always focus on investment quality first, especially when researching aggressive stocks that have the potential for higher returns.
Make sure the aggressive investments you do make are diversified across the five main economic sectors: Manufacturing & Industry, Resources, Consumer, Finance, Utilities
Be wary of stocks that have huge media hype. This also means downplaying stocks that are constantly in the broker/media limelight.
Bonus Tip: Value Stocks
Academic studies suggest that on average, value investing produces better results than growth investing. But these studies mostly look back on what would have happened in a particular historical period, if you followed a particular set of rules. Most distinguish between growth and income investing by looking at average p/e’s (per-share price-to-per-share earnings ratios). They assume high p/e’s are a marker for growth stocks and low p/e’s for value stocks. As any serious value or growth investor can tell you, it’s more complicated than that.
Most successful investors own some growth stocks and some value stocks at any given time, depending on where they see the best opportunities. The two can make a good combination. Growth stocks can be top performers when the company is in fact growing—although a single quarter of bad earnings can send a growth stock into a deep but often temporary slide.
Value stocks can test your patience by moving sluggishly for months if not years. But they can make up for it by suddenly shooting up when the market discovers their value.
So what are growth stocks as a fit in a top-performing portfolio? If you balance and diversify your portfolio as we recommend, it should include both growth and value selections. However, in both areas, you should avoid extremes.
What are growth stocks to your portfolio? Are you in or out? Comment and let’s discuss.
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