Stock market investing isn't nearly as complicated as many Wall Street professionals would have you believe. The truth is that by applying a consistent approach that honors a few key financial principles -- such as diversification, prudence, and long-term thinking -- anyone can build a portfolio that's tailored to their particular retirement goals.

Growth investing is one of the most popular styles out there, and here we'll take a comprehensive look at the steps involved in taking advantage of this strategy.

A woman stacking coins up in piles of increasing height.

Image source: Getty Images.

What is growth investing?

First, it's helpful to understand what growth investing is -- and what it isn't. The approach refers to buying stocks attached to businesses that have attractive characteristics that its rivals lack. These can include easily measurable things such as market-beating growth rates in sales and/or earnings. They can also include more qualitative factors such as strong customer loyalty, a valuable brand, or a formidable competitive moat.

Growth stocks tend to hold promising positions in emerging industry niches that feature long runways for expansion ahead of them. Because of this desirable potential, and the unusually strong success the business has had in recent years, a growth stock is priced at a premium that reflects the optimism investors have in the company. As a result, the simplest way to know whether you're looking at a growth stock is if its valuation, traditionally its price-to-earnings multiple, is high relative to the broader market and its industry peers.

This approach contrasts to value investing, which focuses on stocks that have fallen out of favor on Wall Street. These are stocks with lower valuations that reflect more modest sales and profit prospects. Both investment strategies can work if applied consistently, but investors usually gravitate toward one side of the spectrum or the other.

Growth investing is seen as more risky for two main reasons. First, it involves paying more, in relative terms, and so there is a greater potential for stock price declines. Second, because so much of a growth stock's value is predicated on future gains, even a small change in investors' perception of that potential could have a large impact on the share price. That volatility is why, while it generally makes sense to have a minimum five-year timeline when investing in the stock market, growth-focused investors benefit from an even longer horizon.

So now that you know growth investing is for you, let's take a closer look at the steps involved in fully capitalizing on the strategy.

 

Step 1: Prepare your finances

A good rule of thumb is that you shouldn't buy stocks with cash that you believe you'll need in the next five years, at least. That's because while the market generally rises over the long term, it frequently posts sharp drops of 10%, 20%, or more, that occur without warning. One of the biggest mistakes you can make as an investor is putting yourself in a position to be forced to sell stocks during one of these down periods. Ideally, you'll instead be ready to buy stocks when most others are selling.

Thus, your biggest asset as a growth investor is a rock-solid balance sheet of your own, since it (1) helps finance routine stock purchases and (2) protects your finances, and your emotions, during those inevitable bear markets that are even more pronounced with respect to growth stocks.

Here are a few financial bases to cover before investing in the stock market, but especially in more volatile growth stocks:

Step 2: Get comfortable with growth approaches

Now that you're on the path toward stronger finances, it's time to arm yourself with another powerful tool: knowledge. After all, there are a few flavors of growth investing strategies you can choose to follow. 

You can focus on only large, well-established businesses that already have a history of generating positive earnings, for example. Your approach could be anchored in quantitative metrics that fit in stock screeners, such as operating margin, return on invested capital, and compound annual growth. On the other hand, many growth investors aim to purchase the best-performing businesses around, as evidenced by their consistent market share gains, with less of a focus on share prices. 

It often makes sense to focus your purchases in industries and companies you know particularly well, too. Whether that's because you have experience in, say, the restaurant industry, or in working for a cloud software services business, that knowledge will help you evaluate investments as potential buy candidates. It's usually preferable to know a lot about a small segment of companies than it is to understand just a bit about a wide range of businesses.

What is critical to your returns, though, is that you consistently apply the strategy you choose and avoid the temptation to jump from one approach to another simply because it seems to be working better at the moment. That method is called "chasing returns," and it's a sure way to underperform the market over the long term.

Avoid that fate by becoming familiar with the tenants of this stock market investing strategy. Reading a few classic growth investing books is a great place to start:

  • One Up on Wall Street by Peter Lynch. This classic growth-investing introduction helps explain how individual investors can not only match but also beat the performance of most Wall Street analysts by focusing on a few key characteristics. 
  • Common Stocks and Uncommon Profits by Philip Fischer. Fischer is one of the pioneers of growth investing, and this book lays out the principles that formed the basis for his approach, which went on to influence Warren Buffett in addition to countless other successful investors.

Then, acquaint yourself with the masters in the field and what these billionaire investors did differently than others.

For example, T. Rowe Price is credited as being the father of growth investing, and even though he retired from the field in 1971, his influence is still being felt today. Price helped popularize the idea that a company's earnings growth could be projected out over many years, which shifted investors' thinking at a time when stocks were considered cyclical, short-term investments.

Buffett is normally described as a value investor, but elements of his approach are of the growth variety. This quote from Buffett is a classic articulation of the strategy: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." In other words, price is an important part of any investment, but the strength of the business arguably matters just as much, if not more.

Stock prices are a rough approximation of the earnings that a business will produce through its life, after all. That means investors can accrue massive returns over the long term if they own companies that have persistent advantages their over peers that lead to higher actual results than expected. These advantages can include pricing power that allows a company to generate far higher profits than its rivals. Apple's domination of global earnings in the smartphone industry is a good example of this trend.

A company might also be the cost leader in an industry, which allows it to offer unbeatable low prices. Warehouse giant Costco has used this strategy to become the second biggest retailer in the world.

Lynch liked to emphasize simplicity in his approach to growth investing. "If you're prepared to invest in a company," he has said, "then you ought to be able to explain why, in simple language that a fifth-grader could understand, and quickly enough so the fifth-grader won't get bored." This idea can help you steer clear of investing in popular growth stocks whose businesses you don't understand.

Step 3: Stock selection

Now it's time to prepare to begin making investments. This part of the process starts with you deciding just how much cash you want to allocate toward your growth investment strategy. If you're brand new to the approach, it might make sense to start small, with, say 10% of your portfolio funds. As you get more comfortable with the volatility, and as you build up experience investing through different types of markets (rallies, slumps, and everything in between), this ratio can rise.

A man looks at a sheet of paper using a magnifying glass.

Image source: Getty Images.

Risk plays a big role in this choice, too, since growth stocks are considered more aggressive, and thus more volatile, than defensive stocks. That's why a longer time horizon generally allows more flexibility to tilt your portfolio toward this investing style.

A good way to check whether you have too high of an allocation toward growth stocks is if your portfolio makes you anxious. If you find yourself worried about potential losses or fretting over past market drops, you might want to reduce your exposure to individual growth stocks in favor of more diverse options. 

Buying growth funds

The easiest way to gain exposure to a diverse range of growth stocks is through a fund. Many retirement plans feature growth focused options, and these could form the basis of your investing strategy.

Stepping further out into self-directed choices, consider purchasing a growth-based index fund. Index funds are ideal investment vehicles because they deliver diversification at lower expenses than with mutual funds. That's because, unlike mutual funds, which are run by investment managers who try to beat the market, index funds use computer algorithms to simply match the return of the industry benchmark. Since most investment managers fall short of that benchmark, you'll usually end up ahead of the game with an index fund.  

Index Fund Annual Expense Turnover
Vanguard Growth Index Fund 0.17% 8%
SPDR S&P 500 Growth ETF 0.04% 20%
iShares Russell 1000 Growth ETF 0.2% 13%

Data sources: Vanguard, SPDR, and iShares prospectuses.

For example, the Vanguard Growth Index Fund charges annual fees of below 0.2% and owns a collection of the market's biggest, most successful growth stocks. Its turnover, or the percentage value of the portfolio that is bought or sold in a given year, is just 8%, which means investors benefit from lower transaction costs and a long-term ownership approach.  

The SPDR S&P 500 Growth ETF captures the return of growth-focused stocks on the S&P 500, which makes it a good option as well. Its expenses are about as low as possible, but the fund tends to buy and sell more securities in a given year.

Finally, the iShares Russell 1000 Growth ETF is an attractive choice for investors who want diversity that reaches beyond just the 500 stocks that make up the S&P 500.

Screening for growth stocks

If you'd like to take another step into the do-it-yourself realm, you can buy individual growth stocks. This approach has the highest potential for market-beating returns, but it also carries much more risk than investing in a diversified fund.

To find growth stocks, screen for factors such as these: 

  • Above-average growth in earnings per share, or the profits that the company generates each year.
  • Above-average profitability (operating margin or gross margin), or the percentage of sales a company turns into profits.
  • High historical growth in revenue, or sales. 
  • High return on invested capital, which is a measure of how efficiently a company spends its cash.

At the same time, you'll want to watch out for red flags that raise the riskiness of a business. A few examples: 

  • The company booked an annual net loss in the past three years. This isn't a deal-breaker for most growth investors, but it does suggest that a company has yet to build a sustainable business model. 
  • The company carries a low market capitalization (of, for example, below $500 million). Tiny stocks are vulnerable to bigger competitors and many other disruptions that could threaten their entire businesses. As a result, many investors feel comfortable beginning their search in the "mid-cap" range of stocks valued at $2 billion or greater.
  • There was a recent management shakeup, particularly in the CEO position.
  • Sales and/or profitability is falling. It won't qualify as a growth stock if its core operating metrics are headed lower.
  • There's excessive debt. This point can vary by industry, but the least risky companies tend to have balance sheets that are free, or nearly free, of debt. Carrying significant liabilities, on the other hand, can get a company into trouble during industry downturns. 

A stock screen is just a starting point for investment research, since the best long-term investments are characterized by factors that are hard to quantify, such as brand strength and competent leadership. A strong brand helps with customer loyalty and allows room for raising prices over time. A solid management team is critical, because growth-focused companies need to be flexible in adapting to changing market conditions. 

Still, screens help limit your search to a more manageable list that you can then scrutinize for signs that you've got a good growth investment on your hands.

Step 4: Maximize returns

Growth stocks tend to be volatile, and while your aim should be to hold each investment for a minimum of several years, you'll still want to keep an eye on significant pricing changes, for a few key reasons.

  1. If a portion of your holdings has gained so much value that it dominates your portfolio, it might make sense to reduce your exposure by rebalancing your portfolio.
  2. If a stock rises far above your estimate of its value, you can consider selling it, especially if you've identified other, more reasonably priced investments to direct the funds toward.
  3. If the company has hit a rough patch that has broken your original investment thesis, or the reason you bought the stock in the first place, you might want to sell. A broken thesis might include major missteps by the management team, a long-term decline in pricing power, or disruption by a lower-priced competitor.

These are just some of the many reasons an investor might want to make adjustments to their portfolio by deciding to sell a stock.

Yet assuming you did your homework when you initially purchased your stocks, in most cases your job will amount to sitting still, being patient, and allowing the power of compounding returns to grow to its full impact on your portfolio over the next 10, 20, 30 years or more.

Demitrios Kalogeropoulos owns shares of Apple and Costco Wholesale. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Costco Wholesale. The Motley Fool has a disclosure policy.