When it comes to investing there are different schools of thought. Your investing strategy and asset allocation will depend on what you hope to get out of your investments. Are you looking to score deals on under-valued stocks or find companies that are on their way up? Let us explain how growth investing works and its potential pros and cons for the average investor.
Growth Investing Basics
Many people buy index funds or mutual funds instead of trading individual stocks. This approach can potentially save you time and money, depending on how the fund fees compare to the trading fees. Still, there are always people who prefer to invest at least some of their money in individual companies’ stocks, either because they enjoy it as a hobby or because they think they’ll earn higher returns that way.
If you decide you want to research companies and hand-pick your stocks, how do you know what to buy? One approach is to look for stocks that seem to be trading for less than they’re worth based on the real or potential value of the company that’s issuing the stock. This approach is known as value investing.
A different approach is to look for companies that are growing quickly. These could be companies that have recently gone public and are likely to be growing and expanding. As you might expect, this approach is known as growth investing.
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Why Growth Investing?
If you opt for growth investing, you’re probably not too concerned with getting fat dividend checks in the mail. The kind of young, lean companies that growth investors target are not the establishment companies that channel their earnings into big dividends for shareholders. Instead, they’re likely to reinvest their earnings.
So if growth investors aren’t in it for the dividends, what are they hoping to get? Growth investors expect the value of the stock they own to rise. That means that down the road growth investors could “sell high” what they bought for a relatively low price, realizing capital gains in the process.
If you decide to go the growth investing route, remember that the tax rate you’ll pay on your capital gains will depend on how long you wait between buying and selling. Long-term capital gains are taxed at a lower rate. You should also be aware that, depending on the outcome of the 2016 presidential election, the capital gains tax regime and rates could change.
As always when you’re investing, keep in mind that past performance doesn’t guarantee future performance. You could do extensive research and learn that a company has been growing at above-average rates for the last several years. That doesn’t mean those growth rates will continue after you invest in the company’s shares. Growth could slow or halt altogether.
Another potential drawback to the growth investing strategy is the risk involved. The very companies that grow at above-average rates when the market is rising overall can tank at above-average rates in the event of a market downturn. If you have a high risk tolerance and plenty of extra money to put on the line, you may not be bothered by this. But it’s worth keeping in mind.
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Many investors who want their money to grow into a reasonable retirement income can probably get away with some low-fee index funds, with the ratio of stocks to bonds decreasing as retirement approaches. But for those who enjoy the challenge of researching their individual investments, growth investing offers the potential for high rewards – assuming you know how to pick winners.
This article originally appeared on SmartAsset.com.