What is a growth stock?
A share in a stock is a financial instrument that provides the owner of the share with partial ownership equity in the company that issued it. Investors differentiate between stocks by classifying them into different categories such as defensive and growth stocks.
Growth stocks are those of companies that are known for generating revenue and profits faster than the industry average. Their stocks will be expected to grow faster and provide larger returns than the rest of the market. Let’s take a look at an example of a growth stock – Shopify (SHOP).
As of 1 September 2021, Shopify was up 35% year-to-date (YTD). When compared against the S&P 500 Index (US500), which was up 20%, Shopify had outperformed the index by 15%.
If we take a look over the past five years, Shopify has grown 3,660%. This means that if an investor had invested $1,000 into the stock five years ago, their investment would be worth $37,600 on 1 September 2021. By comparison, if they had invested that same $1,000 into an exchange-traded fund (ETF) that tracks the S&P 500, SPDR S&P 500 ETF Trust (SPY), which had gained 107% over the same period, their investment would be worth $2,070 (excluding dividends).
Delivering massive returns, growth stocks are looked upon rather favourably by many investors.
It’s worth noting that investing capital in any asset incurs risks. An asset’s past performance is no guarantee of future returns. Share prices of stocks that are considered growth stocks today might plummet tomorrow. You should always do your own research before investing. And never invest money you cannot afford to lose.
Where have you heard of growth stocks?
Since growth stocks are inarguably more exciting investments than their defensive peers, it is likely that you will have heard of them. The promise of larger returns in shorter time frames leads many investors to add healthy amounts of growth stocks into their portfolios.
What do you need to know about growth stocks?
Growth stocks are not suitable for every investor. They are typically more volatile than defensive stocks and these companies are much less likely to pay dividends. In fact, of all the growth stocks mentioned above, only Apple has ever paid a dividend to its shareholders as of 1 September 2021.
Growth stocks also tend to carry quite lofty valuations and it is not uncommon for the value of the stock to be priced to perfection. This means that the valuation of the company is based on the presumption that everything will go as planned. If things go array, the stock might go down just as quickly as it soared higher. As a result, investors who are unable to incur too much risk in their investment portfolios may choose to shy away from growth stocks.
Ideally, apart from higher tolerance for risk, growth investors will also have a long-time horizon for their investments. Growth companies can take a long time to mature and investors may need to wait years before their investments actually begin to grow.
Keep in mind that volatility is a large part of growth investments; and a higher potential upside comes with a higher risk of downside.
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