Your investing style and tolerance for risk can help determine what type of stock mutual funds you invest in. The two main types of funds — growth and value — have different characteristics that can match your investing style.
Owning a mix of both funds is probably a smart move, but it can still be worthwhile to understand how each fund works. Here are some short explanations of growth vs. value funds:
Growth businesses are likely to reinvest profits, instead of paying out dividends to shareholders, as a way to grow. Growth stocks can be seen as expensive and overvalued.
Growth stocks tend to be newer companies with products that are expected to be in high demand in the future.
Value funds are stocks that are undervalued by the market, meaning their prices don’t reflect their fundamental worth. They can trade at a lower price when compared to their fundamentals.
Value stocks can be undervalued for various reasons. An earnings report can have some bad news or a company may fall on hard times.
Growth funds are expected to have faster than average growth in revenues, earnings or cash flow. They often have above-market price-to-earnings and price-to-sales ratios as higher sales and earnings justify higher valuations.
Value companies have lower-than-average sales and earnings growth rates, lower dividend yields, and lower price-to-earnings ratios.
Growth funds are expected to offer higher returns than the overall market when stock prices are rising overall, while underperforming the market when stock prices drop.
Value funds focus on perceived safety instead of growth, and often use their earnings to pay dividends. This allows value funds to provide more income than growth funds, though they can appreciate long-term if the market recognizes their true value.
Growth funds generally have a higher risk than value funds, and thus require a higher tolerance for risk, and a longer time horizon, than value funds. The increase of growth funds may not always be realized.
Value funds have the risk of possibly never realizing their intrinsic value. The market may have correctly priced such companies, preventing them from gaining in price.
Whichever investing style you choose, be sure to carefully study the companies you want to invest in and understand the fundamentals behind them before putting your money into them.
Aaron Crowe is a freelance journalist who specializes in personal finance topics.