Everyone knows "that guy." You know the one I'm talking about -- the guy who shows up to the party bragging about how he got a 500% return on an investment in three months' time. You leave the party unsure whether you should punch that guy in the face or beg for his stock tips.
U.S. gymnast McKayla Maroney shows us the proper reaction to "that guy's" boasting.
Stories like that can be hazardous to your wealth. They lead the beginning investor to expect such returns with regularity. And because of that expectation, novices sometimes over-allocate their portfolios toward aggressive growth.
To be clear, aggressive growth should have a part in every portfolio. But your expectations need to be balanced if you want to optimize your returns -- and maintain your sanity.
What is aggressive growth investing?
Oftentimes, when you meet with a financial planner, you're offered a menu of different investment options. These menus usually range from conservative approaches that focus on bonds and CDs to the aggressive approaches that we're covering here.
There's no standard definition for what "aggressive growth" means. But for the purposes of this article, lets assume that using an aggressive growth strategy means:
- Focusing on stock price appreciation rather than income from dividends.
- Investing in companies you believe will continue to grow earnings at a rate far outpacing the broader market's growth rate.
- Accepting the fact that your investment will be highly volatile, doing exceptionally well when the market goes up and exceptionally poor when it goes down. Growth stocks' volatility is usually reflected by a high beta (1.0 or higher).
- Buying shares of companies that are considered overvalued by traditional metrics like the price-to-earnings ratio.
One textbook example of an aggressive growth industry is 3-D printing. Since the Great Recession, folks have been making bold predictions of how the technology could change the world -- from eliminating the need for mass manufacturing to allowing us to print our own food.
A Makerbot 3-D printer, owned by Stratasys, prints a propeller. Source: Creative Tools via Flickr.
The industry's two biggest players, Stratasys and 3D Systems , have all the signs of aggressive growth investments.
3-Year Revenue Growth
3-Year Earnings Growth
44% per year
15% per year
65% per year
33% per year
Source: E*Trade, Yahoo! Finance. Non-GAAP earnings used to calculate P/E. Numbers current as of Aug. 7, 2014.
What are the drivers of aggressive growth investing?
When you invest in companies showing signs of aggressive growth, the most important thing to realize is that the stock market usually has high expectations for the company. Professional investors care little about what a company has recently done and much more about what it will do in the future.
For that reason, any time an aggressive growth company falls short of analyst expectations, its stock will take an outsize hit. And sometimes, even if the company meets or exceeds expectations, its stock will still go down because the company's guidance falls short of what investors were hoping for.
The one exception to this rule is when a company is willing to sacrifice short-term profits for long-term dominance. Sometimes a company shows remarkable revenue growth, but its earnings don't keep pace. If that's because the company is making investments that will help it dominate its field, investors are more likely to forgive the company's stock for the earnings shortfall.
Why invest in aggressive growth companies?
In the end, investing in this field is all about risk tolerance. For every stock that zooms up 200% or more, there are bound to be a number that tank. That's simply the nature of the beast.
Aggressive growth investors need to be willing to take a decades-long view when it comes to their holdings. Worrying about the daily swings in the market -- especially when they hold such volatile stocks -- would drive them crazy.
One of the smartest ways to manage your emotions when it comes to aggressive growth stocks is to make sure you've diversified your portfolio. If you devote a portion of your money to stalwart stocks that pay solid dividends, you'll be less likely to panic when your volatile stocks hit a rough patch.
For those able to take a balanced, levelheaded approach to aggressive growth investing, the rewards can be significant over the long run.
The article Aggressive Growth: Investing Essentials originally appeared on Fool.com.
Brian Stoffel owns shares of 3D Systems and Stratasys. The Motley Fool recommends 3D Systems and Stratasys. The Motley Fool owns shares of 3D Systems and Stratasys. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .
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