There are thousands of publicly traded companies in the U.S. stock market alone, and picking them may be daunting for beginner investors.
One place to start is by dividing the market into so-called growth or value stocks. Here's a primer for investors looking to initiate a new position in the market:
Value stocks trade at a discount to the true value of the stock or to comparable stocks, appearing cheap to some, says John Reese, founder of Validea Capital Management, which runs the Validea Market Legends exchange-traded fund (ticker: VALX) that incorporates value and growth investing strategies. Value investors hope for future price appreciation when the market realizes a company's true value, he says.
Value stocks tend to have lower price-to-earnings ratios and tend to move up and down with global economic cycles, says Jurrien Timmer, director of global macro with Fidelity Investments.
They also typically have a long-term record of growing revenue and earnings per share, have low debt and have a record of increasing their dividends.
Meanwhile, growth stocks exhibit rapid earnings or revenue growth rates compared with their peers and the Standard & Poor's 500 index. They typically trade at a premium to the overall market, Reese says. Growth investors hope the growth continues and leads to rapid stock price appreciation.
However, with that rapid growth comes increased volatility, so investors of growth stocks have to be prepared to weather more of a roller-coaster ride than those who are investing in value stocks. Investors in volatile growth stocks should be realistic about their risk tolerance and their short-term and long-term investing goals. Those investors who have a long-term horizon can afford to dabble in more volatile stocks, while those who are close to retirement age – or who are already using their investment portfolio for their retirement income – should likely steer more toward value stocks.
Over time, value investing tends to perform better than a growth investing strategy. That's because investors may discover that there has already been too much enthusiasm in some growth stocks, which can lead to disappointment, Reese says.
In the shorter term, growth stocks have outperformed in the first nine months of this year, says David Katz, chief investment officer at Matrix Asset Advisors, which has a philosophy focused on value stocks. He says now recalls a time in the late 1990s when growth had done very well because of technology stocks, but then stagnated because of high valuations. As growth may now start slowing down, that could leave value stocks poised to do well, he says.
"I would recommend people hold both," Reese says. The market tends to reward each type of stock at different times in a business cycle, but he has found no successful formulas for predicting whether the market is in a growth phase or a value phase.
Reese recommends having a stock portfolio made up of around 60 percent value stocks and 40 percent growth stocks.
In addition to both types of stocks, typical investors also want diversification between large and small stocks, as well as geographic diversification, Timmer says. For instance, large-capitalization stocks have a market capitalization greater than $2 billion and primarily trade on the Dow Jones industrial average and the Standard & Poor’s 500 index.
Their smaller-cap brethren, meanwhile, have market caps from $300 million to $2 billion and are usually found on the Russell 2000 or the S&P SmallCap 600. Small-cap stocks have more room for growth, but large-cap stocks are generally seen as more stable.
One way to keep a balanced portfolio is to buy diversified, actively managed mutual funds that invest in a cross section of companies, Timmer says. The Fidelity Balanced Fund (FBALX) and Fidelity Puritan fund (FPURX) are examples of funds that balance different types of stocks, says Nicole Goodnow, a Fidelity spokeswoman.
Exchange-traded funds that track growth or value stocks can also make sense, but they can mean more diversification homework for individual investors, Timmer says. Because the S&P 500 contains both kinds of stocks, funds that track that index would offer a good mix of both, Katz says.