Question 12.3: Investing in Growth Stocks The term growth stock is frequent...
Investing in Growth Stocks
The term growth stock is frequently used as a euphemism for small-company stock. Are such investments suitable for “widows and orphans”? Before answering, you should consider the historical volatility. For example, from the historical record, what is the approximate probability that you will actually lose more than 16 percent of your money in a single year if you buy a portfolio of stocks of such companies?
Looking back at Figure 12.10 , we see that the average return on small company stocks is 16.7 percent and the standard deviation is 32.6 percent. Assuming the returns are approximately normal, there is about a 1/3 probability that you will experience a return outside the range of -15.9 to 49.3 percent (16.7% ± 32.6%).
Because the normal distribution is symmetric, the odds of being above or below this range are equal. There is thus a 1/6 chance (half of 1/3) that you will lose more than -15.9 percent. So you should expect this to happen once in every six years, on average. Such investments can thus be very volatile, and they are not well suited for those who cannot afford the risk.
