As you establish an investment portfolio, it’s important to think about the types of assets you want to include. It’s a decision that’s typically based on such factors as your long-term goals, short-term goals, and level of risk tolerance.
Among the options, you might consider are growth stocks and value stocks. These two types of assets have fundamental differences in terms of price, expected performance, and level of risk, but often you may want to have a mix of both in your portfolio.
Growth stocks vs. value stocks
There are many differences between growth and value stocks. Each of these asset types offers valuable benefits and drawbacks worth carefully considering. And depending on your specific goals, both can play a valuable role in an overall investment strategy.
Growth stocks: A growth stock is one that is expected to increase in value and beat the market, delivering higher-than-average returns over the long term. Growth stocks are typically from businesses or industries that are expected to expand. Because these stocks are expected to do so well, you may pay a premium for them.
Growth stocks are those with strong potential to outperform, mostly due to prospects for stronger earnings growth,” says Kevin Gordon, senior investment strategist at Charles Schwab. “They’re often considered ‘high fliers’ given their significant outperformance at times, such as during the tech boom in the late-1990s. But with that comes elevated risk when a downturn approaches.”
Value stocks: Value stocks on the other hand are shares of companies that for one reason or another are deemed to be undervalued. As such, these stocks trade at a discount relative to the company’s assets.
“Value stocks are trading below their intrinsic value and are often viewed as hidden gems in the market,” says Gordon. “Many (not all) value stocks tend to be tied to the economic cycle, which means they tend to perform well when a recession is ending and a new cycle is starting, and vice versa.”
View this interactive chart on Fortune.com
What is a growth stock and how do they work?
A growth stock is a share of a company that’s expected to grow at a rate higher than the average growth rate of the market. Companies that fall within this category are generally prioritizing rapid growth, whether that’s increasing revenues, developing new products, expanding market share, or moving into new geographies.
“Most notably, growth companies are investing profits back into their businesses in an effort to fuel future success,” says Clay Gardner, co-CEO and co-founder of the investment platform, Titan. “All businesses at one point or another start as growth businesses, looking to own their respective categories and create lasting business models.”
Another feature of growth stocks is that they are usually expensive. Their share price is typically high when compared to present earnings. These stocks are also riskier by some measures because there’s no guarantee of future success.
Pros and cons of growth stocks
There are many benefits associated with growth stock investments but these assets are not without risk.
Pros:
- May outperform the market: Growth stocks are expected to grow at a rate higher than the market average.
- Capital gains: These stocks are expected to increase in value over time, which an owner would cash in on by selling the stock once it appreciates.
Cons:
- Expensive: Growth stocks are typically high priced, particularly in relation to their present earnings.
- Higher risk: These stocks may be volatile and have the potential to crash, which can be a costly failure given that they’re typically costly assets to buy.
- No short-term returns: The payoff with growth stocks requires patience as they take time to grow in value.
What is a value stock and how do they work?
A value stock is any share of a company that is trading at a level that’s perceived to be lower than its intrinsic value, and thus, there may be value to be found.
“Value-oriented businesses are typically older, more established businesses with proven track records of success,” says Gardner. “Value stocks can be categorized by high levels of profitability and consistent, albeit lower, growth.”
Some examples of value stocks include Target, Exxon, and Bank of America, all large-scale businesses with decades of proven success.
Another important point about value stocks is that compared to growth stocks, these companies typically prioritize free cash flow and return profits to investors, providing income in the form of dividends or share buybacks rather than aggressively reinvesting that money back into the business.
“Value investors can expect to benefit from both profits (income) and moderate levels of share price appreciation as the market better appreciates those profit streams over time (growth),” explains Gardner.
Pros and cons of value stocks
Pros:
- Provide income: Unlike growth stocks, value stocks may provide near-term income in the form of dividends.
- Undervalued: These stocks tend to be underpriced or relatively inexpensive when compared to the company’s perceived
- Less volatile: Value stocks are typically more established companies that have a history of providing protection in a bear market.
Cons:
- Take longer to appreciate: Value stocks may take several years to grow in price and thus require patience.
- Potential dead end: There is no guarantee that value stocks will ever appreciate in value.
- Challenging to identify: Finding a true value stock, one that is undervalued at the current time and may appreciate once there is a market correction, requires an experienced investor.
How to choose between the two
Assembling portfolio assets is a highly personal decision for each investor, one that should be based on short-term goals, long-term goals, risk tolerance, and any other financial needs you may have.
Growth stocks tend to be more volatile, expensive, and take time to reach their full potential. As such, they may be best used in pursuit of long-term financial goals. Value stocks, on the other hand, tend to be more consistent in terms of earnings, less risky or volatile, and often provide a good choice for earning higher short-term income.
However, when contemplating value and growth stocks, you don’t necessarily need to choose one at the exclusion of the other. In fact, some experts suggest a well-diversified investment portfolio will include a balance between both.
“A winning portfolio includes both a long-dated allocation towards outstanding growth businesses and an allocation towards less volatile, more consistent value-oriented companies,” says Joe Percoco, co-founder and co-CEO of Titan.
