Growth funds and value funds represent the two major investment strategies a mutual fund can adopt. Both approaches have unique strengths and weaknesses, and neither strategy is universally superior. Under specific market conditions value funds tend to perform better, while under other conditions growth funds tend to do better. Furthermore, the investor's goals and risk tolerance also play a role in selecting the right fund.
When seeking value, the fund manager looks for solid firms with good immediate business prospects and undervalued stock prices. Generally, such managers tend to go after unloved stocks, which have seen either a sustained price decline or failed to appreciate as the broad market advanced. Value firms tend to be in stable and relatively boring businesses with few growth prospects. A utility firm supplying electricity to a large area, for example, is unlikely to grow its business. However, such firms also face relatively few risks. Demand for electricity is highly unlikely to decline. With an exclusive contract in place, the electricity supplier practically enjoys guaranteed demand.
Companies with a great deal of potential for growth also tend to face bigger risks. First, such companies operate in "juicy" markets and face stiff competition. Growing markets attract a lot of newcomers and can witness price wars to lock in a customer base for the future. If the cell phone market is rapidly growing in a nation, for example, you will see tons of ads and very attractive offers, such as free phones and unlimited talk time, to lock in customers. In such markets, usually a few winners emerge over the long run and their stocks tend to do very well. Many other competitors are left behind, however, and even bankruptcies are highly common. Trying to pick the winner in such markets is therefore a highly risky game where both the potential reward and the risk are significant.
When selecting a mutual fund, the first question you should ask yourself is how much money you can afford to lose. Can you endure seeing 10 percent to 20 percent of your investment evaporate and still sustain your lifestyle, albeit with a few cutbacks? Or would you rather give up the potentially wonderful returns but sleep better at night, knowing that huge losses are quite unlikely? If you are somewhere in the middle, as most investors are, and are willing to take some risks without putting it all on the line, you should hold both value and growth funds. By adjusting the proportions of the two types of funds in your investment portfolio, you can find the right balance where the risk is tolerable for you, without giving up much in terms of growth potential.
When selecting an investment fund, you should also consider the general economic climate. In a growing economy, growth stocks tend to outperform value shares. When the economy is going through a tough patch, however, the more stable firms that value funds tend to invest in are usually a better choice. A slow economy presents a challenge for growth firms and fewer new businesses succeed in tough times. A company with almost guaranteed demand, on the other hand, suffers far less and its stock offers a safe heaven for the investor's money during such times.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.