One popular investing strategy is to buy shares of companies that are positioned to rapidly increase their profits, or earnings. Most companies' stocks are valued as a multiple of their earnings; therefore, when a company's earnings grow, its stock value tends to follow suit.

While investing in growth stocks can be hugely rewarding, this strategy isn't for everybody. That's because growth stocks come with greater risks than the shares of more stable, slow-growing companies. Let's take a closer look at what a growth stock is, what risks are involved in growth investing, and how growth investors can manage their risk.

Scale showing risk and reward

Image source: Getty Images.

What is a growth stock?

Broadly speaking, a "growth stock" is a company that has increased its profits at a much faster rate than the average business in its industry and is expected to continue doing so in the future. However, companies that have not yet reached profitability but are experiencing huge revenue growth are often deemed growth stocks, too.

Often these companies have developed a new product, service, or business model, or they're pursuing an acquisition strategy that enables them to rapidly grab market share in an existing industry. In some rare cases, they're helping to build an entirely new industry from scratch.

Here are a few characteristics that are common among publicly traded growth stocks:

  • Faster-than-average growth: Growth stocks usually boast a history of increasing their revenue, profits, free cash flow, or book value at a much faster rate than average. Importantly, investors usually believe the company's rapid growth rate will continue into the future.
  • A premium valuation: Growth stocks tend to look expensive by traditional valuation metrics such as the price-to-earnings ratio, price-to-book ratio, price-to-sales ratio, price-to-free-cash-flow ratio, and more. The reason growth investors are willing to pay up to own a stock is that they believe that the company will continue to exhibit rapid growth for many years to come. If that growth is achieved, then the share price could rise rapidly and lead to market-beating returns.
  • High volatility: Since many growth stocks trade at a premium valuation, they tend to be much more susceptible to big price swings. In bull markets, growth stocks tend to rise at a much faster pace than the overall market, because investors grow increasingly comfortable with risk when times are good. Conversely, growth stocks tend to decline at a more rapid rate in bear markets as investors seek to reduce their risk profile. Smaller growth companies also have more opportunity to boom, as well as more risk of going bust, which contributes to growth stocks' increased volatility.
  • No dividends: The majority of growth companies choose to reinvest their profits back into the business to drive even more growth. There are many ways that companies can invest in themselves. Examples include spending more on research and development to create new products, increasing their commercial infrastructure to acquire new customers, acquiring competitors or complementary businesses, buying back their stock, and more. Since all of these actives cost money, most growth companies usually don't have extra cash lying around to make dividend payments to their shareholders.

The benefits of investing for growth

Given their lack of dividend payments and high valuations, you may be wondering why anyone would choose to invest in growth stocks at all. The answer is that some growth stocks go on to create huge amounts of wealth for their investors. Some growth stocks have the potential to generate 10, 50, or even 100 times their shareholders' original investments.

This table shows a list of some well-known growth stocks and the incredible returns they've earned for their investors since they went public:

Company IPO Year Share Price Appreciation
Adobe Systems (NASDAQ: ADBE) 1986 119,200% (NASDAQ: AMZN) 1997 86,280%
Chipotle (NYSE: CMG) 2006 956%
Mastercard (NYSE: MA) 2006 4,230%
Microsoft (NASDAQ: MSFT) 1986 104,000%
Monster Beverage (NASDAQ: MNST) 1985 269,300%
Netflix (NASDAQ: NFLX) 2002 30,200% (NYSE: CRM) 2004 3,010%
Starbucks (NASDAQ: SBUX) 1992 16,730%
Tesla (NASDAQ: TSLA) 2010 1,280%

Data source: Yahoo! Finance via Numbers current as of June 11, 2018. 

As you can see, growth investors who buy the right companies and hold them for the long term can turn a few thousand dollars into life-changing amounts of money. 

The pitfalls of growth investing

While some growth stocks go on to generate huge returns for their investors, the unfortunate reality is that many growth companies actually destroy shareholder value over time.

J.P. Morgan released an eye-opening study a few years ago that really hammers this point home. The study evaluated the performance of all the individual stocks in the Russell 3000 Index between 1980 and 2014. J.P. Morgan chose this index because it covered about 98% of the investable U.S. equity market during the time period. Here's an overview of the study's key findings:

  • 40% of the companies in the index fell more than 70% from their peak and never recovered. The odds of failure were even higher in sectors that are generally seen as "growth" industries, such as technology, telecommunications, energy, and healthcare.
  • Roughly two-thirds of all individual stocks underperformed the index over their lifetime.
  • Only about 7% of companies were "extreme winners," i.e., stocks that exceeded the index's returns by more than 450%.

As you can see, the odds that a randomly picked growth stock would beat the market were only about one in three. And the odds that a given stock will be an "extreme winner" are much smaller. These numbers showcase why it is so important for growth-focused investors to diversify. Buying a basket of growth stocks instead of just one or two will greatly increase an investor's odds of buying extreme winners. Since a single extreme winner can offset the losses of many losing investments, diversification acts as both a risk management tool and a method of enhancing long-term results. 

But what causes so many growth stocks to underperform? Here are a few of the risks that growth investors assume when they buy shares in a growth stock:

  • High valuation: Investors who are willing to pay a high valuation to own a growth stock do so because they think the company is capable of growing rapidly for many years to come. Those high valuations reflect high expectations for the business, and sometimes those expectations become so great that it becomes impossible for a company to deliver. And when the company inevitably posts results that disappoint the market, many investors head for the exits at the same time, sending the share price into a tailspin. This also amplifies a stock's volatility, which can be unnerving.
  • Execution risk: Business plans always sound great on paper, but they don't always pan out in the real world. If a growth company stumbles in its attempt to launch a new product or service, then the consequences can be severe. 
  • Scaling risk: Businesses tend to become harder to manage as they grow. Managing a company with 50 employees in the U.S. is one thing. Managing a business with 5,000 employees in multiple countries take another skill set altogether. Some management teams lack the skill set to make the transition.
  • Technological disruption: Many growth stocks operate in fast-moving industries that are disrupting the status quo. While this can lead to spectacular growth when times are good, the disruptor can sometimes find itself being disrupted by a new technology. For example, consider the market for GPS navigation systems in the early to mid-2000s. Companies like TomTom and Garmin (NASDAQ: GRMN) were once red-hot growth stocks as consumers everywhere rushed to put a GPS in their car for the first time. However, these companies were blindsided by smartphone makers like Apple (NASDAQ: AAPL), which made GPS a standard feature of their devices within a few years. Once that happened, most consumers no longer felt the need to buy a separate GPS device.
  • They go in and out of style: The stock market tends to trade in cycles. Sometimes value stocks are all the rage, and thus they vastly outperform growth stocks. Other times, investors fall in love with income stocks, and dividend investing becomes en vogue. If you start buying growth stocks just as Wall Street is starting to focus its attention elsewhere, then you could be setting yourself up to underperform, possibly for years at a time. For example, consider what happened to technology stocks between 1995 and 2002. From 1995 to 2000, technology stocks were all the rage, and investors in the space were making money hand over fist. However, after the bubble finally burst in 2000, technology stocks went on a multiyear slide as growth investing fell out of fashion for many years.

Who should be a growth investor

Since growth stocks tend to be more volatile than the broader market, they're usually a bad choice for people who depend on their portfolio for a steady stream of income, such as retirees. Since retirees need to constantly sell off a portion of their portfolio to fund their lifestyle, they may not be able to wait for the market to recover from a downturn. That could force them to sell their stocks at depressed prices and deplete their nest egg at a far faster rate than they assumed.

Growth investors also need to be entirely comfortable with occasional wild price swings. In fact, investors in some of the greatest growth companies in history have had to endure brutal periods in which their stocks got crushed.

Consider the following peak-to-trough drops in some of the greatest growth stocks of the last few decades:

  • Amazon declined 90% between 1999 and 2002.
  • Starbucks fell 80% between 2006 and 2009.
  • Netflix fell more than 75% from 2003 to 2005 and from 2011 to 2013.
  • Apple declined more than 75% on three separate occasions.
  • Alphabet (NASDAQ: GOOG)(NASDAQ: GOOGL) fell more than 60% between 2007 and 2009.

While all of these companies fully recovered from their falls from grace, investors had no guarantee that they would rebound. Investing in high-growth stocks can be trying at times, so growth-focused investors need to be able to endure this kind of extreme volatility by not selling their stocks during a downturn if they want to be successful in the long term.

Here are a few traits that make an investor suitable for growth-stock investing:

  • They have a strong stomach for risk and volatility: As noted above, even great growth stocks can experience huge price drops from time to time. An iron stomach is a must.
  • They have a long-term time horizon: The biggest gains accrue to investors who are willing to hold their stocks for an extended period of time. Since anything can happen in the short term, investors need to buy growth stocks with the intention of holding them indefinitely. As Warren Buffett likes to say, "When we buy pieces of outstanding businesses with outstanding management, our favorite holding period is forever."
  • They can afford to be patient: Money that's earmarked for spending in the next five years shouldn't be in the stock market at all. Since bear markets can occur at any time, you don't want to put money that you will need to spend in the near future at risk. If you're saving to buy a house, a car, college, or for any other major purchase, your best bet is to keep it in a safe investment such as a CD or savings account. 
  • Their personal finances are under control: Growth investing can be risky, and one sure way to lose is by being forced to sell your stocks at the worst possible time. If a recession hits and you need to liquidate your assets to fund your lifestyle, then you're almost guaranteed to lose. That's why it's supremely important to have your personal finances in order before you think about buying growth stocks. Pay off your debts, build an emergency fund, and make sure your retirement accounts are fully funded before you consider becoming a growth stock investor.

If you feel like you match this profile to responsibly invest in growth stocks, your next step is our step-by-step guide to finding the best growth stocks

Ways to reduce your risk

Here are a few things that growth investors can do to lower their risk profile:

  • Diversify: There's an old adage that you should never put all of your eggs in one basket. That's especially true in investing. The best way for growth investors to protect themselves is to spread their money across many different companies. This helps to protect their portfolio in case a handful of growth stocks turn out to be duds. It's important to know that diversification means more than just buying multiple stocks. Investors need to make sure they diversify by market segment, too. After all, if you buy 15 different small-cap tech stocks, are you really diversified?
  • Limit your position size: When investors get really excited about a business, it's natural for them to want to buy as much of the stock as they possibly can. I've been guilty of this myself. However, the best investors know that deploying capital wisely is a balancing act. That's why I firmly believe that investors should start by allocating only 1% or 2% of their portfolio to a growth stock that they like. While this does limit their upside potential, it also caps their risk. Perhaps the best advice I've ever heard about choosing an appropriate position size comes from Tom Engle. Tom is a master investor who has been sharing his wisdom on The Motley Fool's discussion boards for years. Here's what Tom likes to say when it comes to buying growth stocks: "If this company is the next great growth stock, then a little is all I need. If it's not, then a little is all I want."
  • Avoid companies that are losing money: I'm a big fan of using screening tools to find growth stocks that interest me. One simple way I eliminate risky companies from contention is by only searching for companies that are already generating a profit. Growth stocks that have already achieved profitability tend to be much less risky than those that are still losing money, as they won't have to raise capital through stock offerings (which dilutes current shareholders) or debt issuance (which increases interest expense) just to keep the lights on.
  • Add to winners, not to losers: For a long time, I believed stocks became more attractive only after their price had fallen. However, I've learned the hard way that this isn't the case with growth stocks. I've since become a firm believer that winners tend to keep on winning, and losers tend to keep on losing. For that reason, I like to buy shares in companies that have already experienced strong price appreciation. This means that the company is already doing something that is causing Wall Street to pay attention. Conversely, if a stock has lost badly to the market, then it means that Wall Street is losing faith in the business. I think it's a much better idea to put your money behind the former. 

It's time to start building wealth

Growth investing isn't for everybody, but when done the right way, it can lead to life-changing wealth. If you can develop a process that seeks out some of the best growth stocks and hang on to them for the long term, then you'll put yourself in a great position to generate wealth for your family.