What Is a Growth Stock? Plus When Do They Make Good Investing Sense

High risk, high reward. These are two defining characteristics of growth stocks, but how do you know if it’s right for you? Here we break down the basics of this investment approach.

What Are Growth Stocks?

A growth stock refers to shares of a company whose earnings are expected to grow at a faster rate than the market. For example, a company may have a highly innovative product that is likely to sell well, so it’s expected that the company will outpace competitors in its market.

Growth companies are often young, up-and-coming companies in rapidly evolving industries, like technology, and their stocks typically trade at a high price-to-earnings ratio, meaning investors are willing to pay higher share prices with the expectation that they’ll be able to sell them at even higher prices later when the company’s net profits grow.

What Are the Top Advantages of Investing in Growth Stocks?

HIGH REWARD

Growth companies are predicted to see higher average earnings regardless of current economic conditions, which means investors may see high earnings if they ride out market dips and stick with a company long-term.

INFLATION-RESISTANT

Growth stocks can also be an inflation buffer. In theory, a growth company’s net profits should continue to increase with inflation (after an initial adjustment period), so as long as investors stick with the company, they will often see their money continue to grow as well.

What Are the Biggest Risks?

NO DIVIDENDS

One of the biggest disadvantages of growth stocks is that they rarely pay dividends, as these companies usually want to reinvest any retained earnings back into their business. This means investors can only earn money on their investment when they sell their shares.

HIGH RISK

Growth stocks may have a high level of reward, but they also have high levels of risk. Individuals are investing in expected growth, which isn’t guaranteed. Stock prices could decline significantly with any drop in the company’s perceived value.

What You Need to Consider Before Investing

When deciding whether growth stocks make sense for you, make sure to keep these critical factors in mind.

TIME HORIZON

Your decision to invest in growth stocks should depend partially on how long you can wait before needing your money back, also known as your time horizon. Growth stocks are usually not considered a short-term investment strategy because you need long periods of time to realize the stock’s full potential.

RISK TOLERANCE

Given the high risk that comes with growth stocks, it’s critical to consider your own risk tolerance—how much risk you are willing to take. To determine your risk tolerance, you might look back on behavioral habits, such as decisions you’ve made in the past when markets took a bad turn.

In addition to your willingness to take on risks, consider your ability to handle them, which might change depending on your personal and financial goals and circumstances. For example, if you have other major financial responsibilities that require immediate income, such as kids beginning college, long-term and high-risk investments may not be the best move for you.

INDUSTRY & COMPANY KNOWLEDGE

Growth companies typically start as smaller businesses in emerging or fast-moving sectors, so if you want to see the highest returns, you’ll need to be confident in your ability to select winning companies from a given industry.

Growth Stocks and Your Financial Planning

A successful financial plan involves using a variety of tools to help you meet your goals, not just investing money in the stock market. That being said, growth stocks can be an effective strategy for growing your wealth if the natural volatility and initial investment costs work for you.

Not sure how growth stocks fit in with your financial planning? Contact us today to learn how Ironwood Wealth Management can help you find the approach that works best for you.