Anybody who invests in the stock market wants to find stocks that are going to appreciate in value, right? Of course! That’s the purpose of investing and to do that, we need to find growth stocks.
What are growth stocks? Simply put, these are stocks that are expected to gain more value then the market.
I know, a whole lot of big words that need explanation and here at elementary-finance, where we provide you an introduction to finance, you can be sure that by the time you’re done reading, you’ll have an explanation that you can understand.
Let’s take a look at the last part of that definition. What does it mean when we say that a growth stock should gain more than the market? Remember that 50% of a stock’s movement is tied to its sector and the sector is tied to the market. The strength of the market is often represented by the S&P 500, an index of 500 stocks that are calculated in to one number. This is what we consider, “the market”
So let’s look at an example. Let’s assume that the S&P 500 has gone up 4% in the last 12 months. Generally speaking, a growth stock needs to have gone up more than 4% in the past 12 months in order to have that label. In other words, the stock beat the market.
We aren’t concerned about where it has been. We are concerned with where it’s going. What a stock did in the past can not make us any money in the future so we have to analyze what we believe it is going to do. In order to find a growth stock, we are looking for a company that is either undervalued right now or is expected to have a positive significant change in the future. That will make us money.
Growth stocks are essential to you making money but if your portfolio is made up of all growth stocks, you probably won’t make a lot of money. Here’s why. Remember that the S&P 500 represents the market. Think of the S&P as the lighthouse in a stormy sea. When you see the lighthouse, you feel better. When you get further away from the lighthouse, you’re taking quite a chance that things may not go so well.
Growth stocks are more volatile. Because they find themselves detached from the market, there is potential for making big money but there is also a significant chance that the stock will cause you a lot of pain. In fact, statistics show that more often than not you will lose money by trying to lock in short term gains from growth stocks. They are too volatile. For that reason, the average investor should have safe stocks with 1 or 2 higher volatility growth stocks.
Remember that growth stocks can be a part of a larger portfolio but it shouldn’t consist entirely of them. Diversification is the key to making money. Not only by having different sectors but also different amounts of volatility.