Know the difference between growth and value stocks so you can include both types in your diversified portfolio to experience superior long-term gains

What is the difference between growth and value stocks? Well, value investing—aiming to buy assets at bargain prices—has natural appeal for those who grew up in strained economic circumstances. Growth investing—trying to identify and buy rising stocks when they have further growth ahead—seems to appeal more to those who grew up in prosperous households.

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.

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Together, growth stocks and value stocks can form a winning combination. A growth stock can be a top performer while the company is growing. However, a single quarter of bad earnings can send it into a deep, though 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 rising sharply when investors discover their true value.

Understanding the difference between growth and value stocks: Value stocks can add to your portfolio’s diversification

Most successful investors will hold some growth stocks and some value stocks at any given time, depending on where they discover the best opportunities.

Value stocks are stocks trading lower than their fundamentals suggest. They are perceived as undervalued, and have the potential to rise. Many technology stocks, for instance, start out as growth stocks and transition into value stocks.

If you invest as we advise—by spreading your investments across the five main economic sectors, investing mainly in well-established companies and staying away from stocks in the broker/media limelight—you will automatically own some growth stocks and some value stocks.

That helps you achieve good results while adding to your portfolio’s diversification. In the end, however, the relative amounts that you invest in growth stocks versus value stocks are less important than your portfolio’s overall diversification and investment quality. 

Understanding the difference between growth and value stocks: Recognize the potential behind growth stocks

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 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 are growing at a higher-than-average rate within their industry, or within the market as a whole, for years or decades.

Understanding the difference between growth and value stocks: Watch out for “value traps”

You need an eye for value to succeed as an investor. But focusing on value measures alone can steer you into unsuccessful investments that are sometimes referred to as “value traps.”

Some of the measures that lead you into value traps are statistical. They include unusually high dividend yields, unusually low per-share price-to-earnings, or P/E ratios, or a low ratio of stock price to book value or other measures of per-share value.

Any of these measures can make it seem like a stock is a bargain. But in fact, any of them can simply be due to a low stock price that is the result of selling by well-informed investors who recognize a dismal long-term future.

Another way to fall into a value trap is to put too much faith in the value of a brand name. A strong brand can sell a lot of strong products, or keep an over-the-hill product going long after competitors have faded. But even the strongest brand name can only do so much.

Follow our three-part Successful Investor approach when buying both value and growth stocks 

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight. 

Do you have a preference for either growth or value stocks? How do you determine your portfolio mix of the two?

Do you feel there’s too much focus on the difference between growth and value stocks? Or does that help you categorize stocks more easily so you can select strategically?