Growth vs value stocks: Which is better for your portfolio?

Glancing at your account statements, you might see both growth funds or value funds as part of your overall investment portfolio.

What do these terms mean? And why do you need both?

The answer, as it is with so many investment-related questions, is diversification. You know the old expression about not putting all your eggs in one basket? That’s essentially the principle behind diversification – a way to include assets with different risk and return profiles in your portfolio. Not all assets perform the same way under the same circumstances or at the same time – that’s why you never want to be too concentrated in one asset class or investment approach.

Regardless of what specific definition of value or growth a specific fund manager might be using, at Edelman Financial Engines, we run an analysis of thousands of investments before designing a portfolio for you that includes elements of each that is in line with your risk profile.

That’s because as a long-term investor, you should have some balance between these two investment styles.

If you focused just on value stocks over the past decade, you would have missed out on the tremendous performance that growth stocks returned. And if you only owned growth stocks, you would have run a higher risk of deeper losses during market downturns. Holding some of each type is a smart way to avoid putting all your eggs in one basket.

So, how do you tell the difference between a growth or value stock to start diversifying your portfolio?

At a high level, the differences between a growth stock and a value stock may include:

• How returns are delivered: Growth stocks are generally expected to deliver returns by way of the share price. Value stocks traditionally tend to include more dividends.
• Market valuation: The market value (i.e., price) of growth stocks can be driven more by expectations of future growth. Is the company growing faster than other companies or faster than the overall economy? Is the company still in the “growth” phase of its life cycle? Growth investors are thinking about the long-term potential – and as a result, shares of growth companies are often labeled “overpriced” relative to fundamental measures like the price-to-earnings ratio.
  For value stocks, the market value is usually closer to the technical accounting or “book” value of the company. Value investors look for companies that appear to be undervalued by the market – that is, trading below their book value.
• Sectors and industries: Growth stocks tend to be in sectors like technology or biotech. Value stocks historically have been most commonly found in sectors like financials, real estate, energy and raw materials.
• Risk and volatility: Growth stocks tend to have a higher level of risk and volatility than value stocks, but along with that can often offer a somewhat higher expected return.

But be careful – in any specific time period, these definitions may not always play out. The old-school definitions of growth and value have been evolving in the last 20 years as the lines between technology and traditional business models continue to blur.

Let’s take a closer look at these different investment strategies to see how they may play a role in a diversified portfolio.

In value investing, an investor is on the lookout for company stocks that are low in price but high in potential. This type of “undervalued stock” is considered a bargain for what it’s worth in the long term if the price eventually rebounds.

But why are value stocks undervalued to begin with? There are a wide range of reasons, from a short-term incident that temporarily tanks a company’s stock price to overall down periods in the industry or market. The hope is that, as time passes, the market will realize the intrinsic value of the company and its share price will rise. However, if the stock doesn’t appreciate, the value investor can still receive money through dividend payments.

Generally speaking, a value stock comes from a publicly traded company that has a low price-to-earnings ratio. While these stock options don’t always boast high-growth returns – especially if they don’t end up appreciating over time – they often offer better dividend yields than the average growth company. For this reason, value stocks are usually considered less expensive and less risky than growth stocks.

Strategically choosing and investing in a value company based on its underpriced stock and potential for future growth can provide numerous benefits, including:

• More stability: Value stocks tend to have less extreme fluctuations than growth stocks.
• Consistent returns: Many value stocks pay substantial dividends to shareholders which can offer a consistent cash flow.

Of course, any investing strategy comes with risks and drawbacks – and value investing is no exception. In general, these options offer lower annual returns than growth stocks. The “intrinsic value” of a company or stock is also entirely subjective. That means two experts can analyze the same company and come to completely different valuations. And no matter what the initial value is, there’s always the potential for a downward trend that causes the share price to drop over time.

But how do these pros and cons stack up against growth investing?

In contrast to value investing, growth investing focuses on companies that currently demonstrate or are expected to have faster-than-average earnings growth. What does this look like?

A growth company is generally one that prioritizes reinvesting its profits into the business instead of putting it toward dividend payments for shareholders. While this means a growth stock won’t necessarily provide a consistent cash flow, the fast growth of the company can increase its share price far more than dividend stocks. However, the uncertainty of higher returns makes this option inherently riskier. There’s never a guarantee that you will profit from a growth stock, and they often experience greater swings in price.

A growth stock is one that expert analysts predict could outpace either a specific market segment or the stock market as a whole over time. It’s also important to note that growth stocks may lose their status after analysts believe they have reached their full potential.

To spot a growth stock, look for companies that have a good chance of expanding in the near future. This could be due to new products, high performance or a variety of other factors and market conditions. The key aspect to look for is whether or not experts believe a growth stock will deliver higher returns than similar stocks.

The primary advantage of investing in a growth company is that you have the potential to earn significantly higher returns, especially over the long term.

While a growth investor might have to contend with more volatility, these market fluctuations are a double-edged sword. On one hand, the stock price for a growth company could take a dive during market downturns – but on the other hand, that volatility could mean unusually high returns.

Outside of volatility, growth stocks also come with a few common pitfalls to keep in mind, such as:

• Speculation: Just like in value investing, it can be difficult to identify a growth company before you miss out on the boom.
• Greater risk: Growth investing inherently comes with greater risks as, despite the potential for higher returns, there is never a guarantee that it will happen.
• Lack of income: Without dividends or the likelihood of short-term returns, growth investing offers little-to-no cash flow or income to investors.

Now that we understand the differences between growth and value stocks, let’s go over some real-world examples so you know what to look for:

• Value stocks: Two common examples of value stocks include the Coca-Cola Company and Procter & Gamble, according to the S&P 500 Value Index, which uses financial ratios of stock price, value and earnings to measure various value stocks.¹
• Growth stocks: Growth stocks often appear in fast-growing or emerging markets, such as the tech industry. For instance, Apple, Tesla and Google are a few examples of well-known growth companies.

When it comes to value vs growth stock investments, there isn’t necessarily a “correct” choice as they aren’t binary options. And, as we mentioned before, these categories aren’t set in stone. Not only can they shift over time, but the stocks themselves can change categories depending on market conditions and company characteristics. Instead, growth and value investing strategies should both be used as parts of an overall diversification strategy. That’s why we generally recommend against favoring one type of stock, but rather diversifying across both.