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Why Young Guns should invest in growth stocks

By now it is well acknowledged that most passive investors in a sensible index beat active managers.  

From a medium term financial returns point of view, the rational move is to invest in a diversified index fund and accept your returns will approximate Beta (ie the market return).  Then sit back and let compounding do its work over a period of 20 – 30 years.

Simple.

Well, not quite.

There are a few factors that I think need to be considered and it might make sense for a young gun on the make to include a few growth stocks in their portfolio.  Here are the key points:

1. Growth stocks provide learning experience

I believe a young gun should invest in a basket of growth companies as this provides an additional learning experience and something else to track along your own journey.

Following growth companies helps build experience in an industry. 

If you invest in 5 innovative SAAS business you get a better feel for the industry via your investments.

It also provides an opportunity to see what moves the company makes.

Public growth companies tend to be some of the better businesses.  There is an element of survivorship bias built in – to get to the stage they are at requires them to be decent business. 

Watching how the business executes can provide very valuable lessons and tips for your own business efforts.

Investors can also see how the management team communicates with the market.  How they frame issues in discussions and calls with investors.  It gives the investor a feel for the industry movements.

Now, you could just follow companies, but I think the lessons are magnified when you have a financial interest in them and it keeps you focussed on a small number.

I would suggest that young investors pick a small basket of 5 or so growth companies in an industry that they like and invest in these companies.  

I would not suggest picking businesses like Facebook, Tesla, Google etc.  These are great businesses but they are all over the headlines.  The information published on them is generally very vanilla and often just media driven speculation.

A small basket of interesting fast growth micro-cap businesses will provide you with better perspective and learning.

Investing a small sum in these companies and following them over time (at least 3 years and ideally more) is key to getting value out of the strategy.  This means you should not touch the capital whilst following these companies (ie don’t sell unless it is clear that the business is in a terminal situation).

2. Beating the market is meaningless with low capital

The point of selecting these growth companies is not to beat the market. It is to learn.

Beating the market, or generating Alpha in finance speak, is great.  It is the ultimate goal of every active investor.

But is it worth bothering about for private investors?

Well the maths is pretty simple.

If you have $100k and the market returns 7%, you just made $7k.

But let’s say you spend 500 hours (c. 10 hours a week) over the course of the year selecting companies that you believe will out-perform. 

You do well and manage to return 14% – double the market return.  Congratulations – that is an outstanding result.

A lot of effort has gone into the stock selection and has resulted in a return of $14k.  A whole $7k more than would have made by putting your $100k in the market.

Spending all of that time to make $7k is not a good use of time.  It would equal a return of approximately $14 per hour.  Not worth it.

Graphic for those visual thinkers

What should you be focussed on then?

3. Spend your time growing your income

Now to be clear, whilst the article is focussed on investing in growth stocks, I don’t want to detract from what you should be spending the majority of your time on.

If you do not have a decent capital base (by which I mean $2m+), you need to spend as much time as possible growing your income and keeping your expenses low so you can grow your capital.

4. Once you have built your capital base

As a sneak peak on the future, lets talk about what to do once you have made it.

For old hand investors with a large amount of capital, passively investing in the index is also not always the right answer.  

The index is “safe” to a certain extent in that the yield that should be relatively consistent over time.  

Clearly there will be drops in the capital value (as we have just seen).  But the portfolio is diversified and consists of robust companies so should always do ok over time.

For investors with a decent capital base (lets say $5m or higher), a more preferable option may be to take a control position in an established niche business (probably a private company).  Acquiring a private business that dominates a small mission critical niche for example would potentially be a better option than passive index investing.

For most of the young guns reading this blog however, this will not be their situation so back to reality and what you should be doing now.

5. Portfolio

For Young Guns today, I wouldn’t advocate allocating more than 10 – 20% of your portfolio to these individual stocks.  It should be a set and follow strategy.

The remainder would be split between the index and dividend stocks to provide income.

This is differentiated advice.  I have not seen anyone else suggest that young guns adopt this strategy so clearly it is not something that is for everyone.

Let me know in the comments if you have any thoughts or any companies that you have invested in.

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