Investing is often categorized into two fundamental styles: value and growth. Value investors look for stocks they believe are undervalued by the market, while growth investors seek stocks that deliver better-than-average returns.
Often growth and value are pitted against each other as an either-or option. It’d be as if you walked into an (admittedly boring) ice cream shop that offered two flavors — chocolate and vanilla — and assumed you could only choose one. But like ice cream cones, portfolios have room for more than one flavor, and together value and growth investments can complement each other.
Before you scoop up a fund of the growth or value variety, here’s what you need to know.
Value and growth at work
Value- and growth-based strategies are among the many asset allocation tools you can use when deciding how to invest in stocks. Some people create their own criteria for picking stocks based on growth or value characteristics. Others let the professionals do the work and invest in mutual funds or exchange-traded funds (ETFs) that adhere to these styles.
If you have a 401(k) or individual retirement account (IRA), you probably have the option to invest in growth and value funds — so that’s one likely place you’ll encounter these strategies.
Value investing 101
Value investors are on the hunt for hidden gems in the market: stocks with low prices but promising prospects. The reasons these stocks may be undervalued can vary widely, including a short-term event like a public relations crisis or a longer-term phenomenon like depressed conditions within the industry.
Such investors buy stocks they believe are underpriced, either within a specific industry or the market more broadly, betting the price will rebound once others catch on. Generally speaking, these stocks have low price-to-earnings ratios (a metric for valuing a company) and high dividend yields (the ratio a company pays in dividends relative to its share price). The risk? The price may not appreciate as expected.
Benjamin Graham is known as the father of value investing, and his 1949 book “The Intelligent Investor: The Definitive Book on Value Investing” is still popular today. One of Graham’s disciples is the most famous contemporary investor: Warren Buffett.
Growth investing 101
By comparison, growth investors often chase the market’s highfliers. You’ve likely seen the disclaimer from financial companies that past performance isn’t indicative of future results. Well, this investing style is seemingly at odds with that idea.
It’s essentially doubling-down: Investors bet a stock that’s already demonstrated better-than-average growth (be it earnings, revenue or some other metric) will continue to do so, making it attractive for investment. These companies typically are leaders in their respective industries; their stocks have above-average price-to-earnings ratios and may pay low (or no) dividends. But by buying at an already-high price, the risk is that something unforeseen could cause the stock’s price to fall.
This style’s “father,” Thomas Rowe Price Jr., developed his philosophy in the 1930s and later went on to found the asset management firm that still bears his name: T. Rowe Price.
How growth and value overlap
Each school has devoted followers, but there’s a lot of overlap. Depending on the criteria used for selection, you’ll see stocks that are included in both value and growth funds. What gives?
In part, it’s much ado about a distinction that’s not set in stone. For example, a stock can evolve over its lifetime from value to growth, or vice versa, says Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management. In addition, investors in each camp have the same goal (buy low and sell high); they’re just going about it in different ways.
“Value investors tend to focus their attention on valuing the continuing operations of a firm, while a growth investor tends to look more at the growth opportunities of the companies they invest in,” Jacobsen says. “It’s important to remember no stock is purely value or purely growth.”
Not an either-or decision
The stock market goes through cycles of varying length that favor either growth or value strategies. The stocks in the Russell 1000 Growth index have outperformed those in the Russell 1000 Value index during the current bull market that began in 2009, but that’s not the case on a year-by-year basis. Value outpaced growth in 2016.
What’s an investor to do? Invest in both strategies equally, advises John Augustine, chief investment officer at Huntington Bank. Together, they add diversity to the equity side of a portfolio, offering potential for returns when either style is in favor. A 50-50 split also helps investors avoid the temptation to chase trends — “and that’s important because consistency is the key to 401(k) investing.”
Investing in growth and value funds adds a layer of complexity to an investment strategy, which is why Augustine recommends it as a secondary step — after diversifying across asset types (stocks and bonds) and classes within (size or region, for example).
Because the market goes in value-growth cycles, these strategies may require a more watchful eye, especially if your 401(k) doesn’t automatically rebalance. When market fluctuations shift your allocations, rebalancing brings it back to your original goal so you’re not unintentionally over- or underinvested in any asset. (Here’s more on rebalancing your 401(k).)
Augustine recommends investors rebalance at least twice a year — a good reminder: “when the clocks change” — or once allocations have gotten out of whack by 5% or more.
In addition to the myth that investors must be growth or value purists, Jacobsen says many people don’t realize these styles ultimately whittle down to an industry discussion. About one-third of “pure growth” stocks in a subset of the Standard & Poor’s 500 index are in the technology industry. Financial stocks have a similar weighting in the “pure value” index.
Finally, don’t get too caught up in the idea these distinctions are make-or-break — effective diversification matters more. Many investors who piece together a portfolio by stock picking stumble upon growth and value unintentionally, Augustine says.
“They’ll find some things that are out of favor and some that are in favor — that’s growth and value,” he says. “The key to value is when you buy. The key to growth is when you sell.”
Anna-Louise Jackson is a staff writer at NerdWallet, a personal finance website. Email: [email protected] Twitter: @aljax7.