5 Reasons to Think Twice Before Investing in Growth Stocks

  • Nov 06, 2019 AEDT
  • Team Kalkine
5 Reasons to Think Twice Before Investing in Growth Stocks

Growth stock is the stock of those companies that are expected to grow at a rate higher than the average rate of the market. A high growth stock is characterised in terms of revenue growth, profitability growth, product launch, acquisitions, patents, branding, etc. These stocks usually reinvest their earnings and do not pay dividends in order to speed up growth in the short term. If the value of the stock increases, one can have a capital gain by selling the stock. No wonder investors can seek profit on such stocks. However, these stocks might not be apt for every investor, as they come with a higher risk than the stocks of companies with slow growth but more stable nature and high quality.

Growth Investing Vs Value Investing
  • Growth and value are the two types of investing in stocks. Neither of the approaches provides the surety of appreciation in the stock market value but both carry investment risks. While growth stock outperforms the market in general, value stocks trade below of what they are really worth and the market expectations.
  • Growth stocks are usually found in nascent industries such as cannabis, while value stocks are found in old, mature industries.
  • Value stocks have low risk and volatility and the growth stocks have more risk and volatility.

Advantages: While there is no assurance on how long the growth can be continued, it surely appeals the investors due to the following advantages:

  • Potential for High Returns: These stocks entice a large number of investors due to the ability for capital appreciation.
  • Tax Efficiency: Growth stocks are more tax efficient than value stocks, as capital gain tax is levied on the stocks than the usual amount.
  • Expert Management: A group of skilled and competent experts manages growth stocks for investors, thus giving the investors access to high expertise.

It is not practical for everyone to invest in growth stocks, as these stocks tend to be more volatile than the market. Growth stocks might be a bad choice for people who expect a steady income, for instance, retirees. They cannot wait for a market to recoup from a downturn and need a fixed income for a basic lifestyle. Therefore, an investor is expected to have a strong stomach for risk and volatility, long term horizon and finances in control in order to invest in growth stocks.

Also Read: [Learn How to Evaluate Growth Stocks]

Let us have a quick peek at the risks involved:

  • Miscalculations: Investors are generally ready to pay a higher amount in order to buy a growth stock because they think the company would grow in the upcoming years and sometimes, these expectations are miscalculated, and it becomes impracticable for the company to deliver. The time when it posts the result, lets down the market which leads the investors to head out from the market at the same time, creating panic. This panic drives the stock volatility, which is alarming.
  • Failure in Execution: Almost all the businesses are based on future expectations, which are uncertain. The business plans which the companies forecast to work out, may fail in the future due to numerous reasons like political instability, environmental concerns, taxes levied, among others. If a growth stock fails to execute its plan to roll out a new product/service, it could result in severe consequences.
  • Managing Risk: When a company grows in a larger firm, it becomes difficult for the management to handle a large number of employees in different countries, with different rules and regulations, and with different requirements. Sometimes, this becomes highly challenging, resulting in stumbling of the share price.
  • Technological Issues: Many growth stock companies usually operate in the environment with high and well operated technology. These may give terrific results for most of the times but may disrupt when the new technology kicks in.
  • Cyclical Stocks: Stocks generally trade in cyclical format and there are times when value stocks outshine growth stocks. During the downturn, investors want to be safe and secure and demand a fixed income from dividends.

Though there are some risks involved in growth investing, a good investor is one who can mitigate the risks and earn money. Some ways to reduce risk on the portfolio are:

  • One simplified way to do this is to include the companies which are generating profits and avoiding those that have lost their money. Growth stocks, which are already on the stage of profitability, tend to be less risky as they don’t raise further capital, hence don’t reduce the shareholdings and also don’t increase the interest expense.
  • People generally have a mindset to buy the stocks whose share prices have fallen, but this isn’t the strategy to accumulate the growth stocks. The companies that have experienced price appreciation implies they have done something to achieve this and may do better in future. On the other hand, if a stock has lost its money, it will take some time to get back on the track. So, it is good to add winners in the portfolio and avoid the losers.
  • It is also important to limit the portion one is investing in a particular stock. When investors are optimistic about the business, they tend to invest as much as possible. It is wise to always balance the stocks they like. It might constrain the returns, but it will also cover the risk.
  • Diversification is always the best strategy, as placing all the eggs in one basket is very risky. Thus, the best way to invest is to spread the money among different companies. This will protect your investments in case one stock turns out to be a failure.
Tips for Choosing Growth Stocks for Investment Portfolio:

It is always good to dig deeper and find a stock that satisfies the criteria as realistically as possible. Some tips to choose a growth stock are as follows:

  • Some developments and changes offer substantial difficulties and prospects for the economy. A strong company in such an economy can be success, therefore investors need to be aware of such trends.
  • It is also important to compare the growth of the company with that of the industry in order to know if it’s a growth stock. For instance, if a company’s earnings rise by 14% in a year for three years or more and the industry’s average growth rate over the same time period is 9%, then the stock qualifies as a growth stock.
  • A stock is not a growth stock because the company performed well, it is so because the growth is consistent over the years. The company’s financial position changes over a period of time, hence it is important to keep an eye on the company’s performance.

Undoubtedly growth investing isn’t for everybody; however, if an investor picks growth stocks in the right way, it can put the investor in a great position, helping to pursue specific goals.


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