Most of us have 401ks, but a lot of people don’t really know what the best way to allocate your money. Most 401k programs require you to invest in set of pre specified mutual funds. Often times one or more of these funds will be invested in growth or value stocks (and a lot of them are a combination of both). How do you know which one to invest in? The first step is understanding the difference between them, and the second step depends on your goals (but I will share with you what I do).
Growth stocks are the glamorous stocks–think sequins and sparkles.
- They are stocks that are projected to have either than average growth rates. Often times this is based on the industry (for example, in recent years technology stocks have fallen into this category) and how that area of the market is projected to grow (such as via economic factors or demographic factors).
- Typically these companies have a return on equity (ROE) that is hire than the industry average, and many times these companies will exceed their earnings projections.
Sounds great right? Well there are caveats to growth investing….
Like most flashy things, they can grow and increase in popularity (just like sequin dresses or tops) but in time they can fall out of favor (i.e. end up on the clearance rack). So when fashion is favoring flashy and sparkly clothes sequin items are fetching top dollar and selling out, but when the trend changes (in the fall people start buying chiffon as an example) the prices on sequin clothing go down. The manufacturer or designer hasn’t done anything differently (and may still be absolutely fabulous) but the market no longer has the demand for sequins so the prices of those items will increase. Growth investing is a lot like following trends, you have to keep your eyes open because what is hot now may not be in a year or two years and therefore may not be the place you want your investment.
So if growth investing is like trendy fashion–fickle and changing–what are value stocks and how are they different? Here are some of the characteristics of value stocks:
- They tend to have higher than average earnings/share ratio (so the amount of the company earns divided by the total number of shares should be better than average)
- They are solid, have a proven track record, are often not in volatile or fast changing industries (this is why they are the more boring stocks)
- Many pay high dividends
- Value stocks typically have a longer holding period than growth stocks
I think of value stocks like classic wardrobe pieces, your little black dress, classic trousers, and pencil skirts–the pieces that season after season, and year after year, are your go-to-pieces. No matter what the current trend is, you know you will always be in fashion for the long term with these choices.
So think of your look like a stock portfolio. It is important to build your look around the classic pieces–well made and well purchased. However it is also important (and to really take your look to the next level) you have to know what trends to adopt and when to let them go. So invest in some value stocks for the long term, and know they will always be there for you. And follow the trends buying and selling growth stocks (or investing a portion of your portfolio in a growth mutual fund). Just know that value stocks are classics and in long term will outperform most growth stocks, but to really get noticed and blow away expectations you will need to take some risks
I put together my 401k like I do my wardrobe. I focus the majority on high quality foundation pieces and add a few trendy items here and there. That is to say the majority of my money is spent on items that are timeless and I can wear over and over again. Then I have a percentage (about 15%) set aside for the higher risk growth stocks (although due to the restrictions of my 401k this is distributed across 2 mutual funds). Of course your investment strategy should depend on your age, your goals, and of course your risk tolerance–but hopefully this gives you a good idea and causes you to take a closer look at your retirement account.