Many people characterize investment styles according to two primary categories: value and growth. Investors often compare the two styles as if they fall into one category or the other. In reality, investors frequently adopt elements of both approaches into their portfolios, but the blend depends on preference, risk tolerance, and investing goals.
Ultimately, including both approaches in your portfolio can lead to greater diversification since stocks tend to fall within the growth or value category. Understanding the difference between these types of stocks and these two fundamental categories is imperative in making intentional decisions about portfolio composition.
What Are the Differences?
The fundamental difference between growth and value investing depends on how investors think stocks will perform in the future based on their current value. Value stocks are stocks that investors believe are currently undervalued by the market, whereas growth stocks are those that investors think will deliver returns higher than the average. Based on this distinction, you can find growth mutual funds and value mutual funds. The first purchases stocks that are likely to deliver high returns, while the latter invests in stocks that will likely gain value in the years to come.
Beyond the belief that value stocks are currently undervalued in the market, these options tend to have low PE ratios and high dividend yields. The primary risk associated with value stocks is the possibility that they will not appreciate as much as expected, which can limit returns and potentially tie up capital for long periods. On the other hand, growth stocks usually have PE ratios that are higher than the market average. In addition, these stocks tend to generate no or low dividends and relatively high volatility, so there is always the risk that you lose money in the investment.
A Closer Look at the Value Investing Approach
People who fall into the value investor camp frequently look for stocks in the market that have low prices but impressive potential for the future. These stocks may be currently undervalued for a number of different reasons, from a short-term public relations crisis to a larger downturn of the larger industry or the whole market.
Investors with this approach purchase stocks they think are underpriced within a particular industry or market in the hopes that the price rebounds. However, there is always the possibility that stocks do not appreciate as expected.
One of the most famous value investors is Warren Buffett, who learned from Benjamin Graham, often called the father of value investing. In 1949 Graham published a book that outlined the basics of value investing. This book remains very popular among investors today, especially because his ideas had such an impact on Buffett. Value investing often means going against the grain and making decisions that other investors would avoid.
The Main Ideas Behind Growth Investing
A growth investor will often track the market’s highest performers, which is very different from the approach of the value investor. Most financial companies will provide the disclaimer that past performance does not indicate future results. Growth investors bet against this idea and put their money on companies or situations that have historically performed very well to make money. Investors with a growth mindset bet on stocks that already demonstrate growth higher than the average in terms of revenue, earnings, or another metric. The companies that attract these investors are usually leaders in their respective industries. However, there is always the possibility that you could lose money by buying at a high price if the stock value falls.
Thomas Rowe Price, Jr. pioneered this approach to investing in the 1930s and under this philosophy founded the asset management firm that still bears his name. While T. Rowe Price uses approaches other than growth investing in its asset management, the founder of the firm had a strong influence on how it conducts its business.
The Overlap between Value and Growth Investing
As already mentioned, value and growth investing have a lot of overlap, and choosing one does not mean you need to forsake the other. Often, stocks are included in both categories depending on the criteria applied in the decision-making process. This is because stocks can evolve from a value to a growth proposition or vice versa. Also, you should know that investors in either camp hope to buy low and sell high even if they wish to do so in different ways. This similarity explains how stocks can fall into both categories. Value investors want companies that have already proven themselves, while growth investors want companies with a lot of potential for the future. In either case, the hope is the same: a significant increase in value. Thus, it is often helpful to include both in your portfolio.