How to invest in tech stocks, a risky but fast-rising segment of the market

Simon Chandler

Nov 14, 2020, 05:00 IST

How to invest in tech stocks, a risky but fast-rising segment of the market

Investors who go for growth find tech stocks an ideal play, even though the sector is volatile.SOPA Images / Contributor/Getty Images

Tech stocks are shares in companies in the technology industry — a huge sector that includes telecommunications, IT, electronics, and computer hardware and software.
Tech stocks offer some of the best growth potential, but — like most high-reward investments — they come with high risks too.
Since many tech stocks are expensive, individual investors can get the most bang for their buck, and minimize risk overall‚ by investing in tech-oriented mutual funds and ETFs.

In investing circles, there's always a lot of talk about tech stocks: "Who's trailing in the tech sector?" "Tech is leading the market rally." "Is the tech bubble finally about to burst?"

But what do we mean by "tech stocks"? Strictly speaking, the term simply refers to shares in companies in the technology industry. This sector is a pretty big one, and it encompasses sub-sectors such as telecommunications, consumer electronics, industrial electronic equipment, computers, semiconductors, hardware, software, and information technology (IT) services.

Though often associated with small, innovative start-ups, the tech sector also includes plenty of powerhouse giants with household names, like Microsoft and Apple.

These and similar high-growth tech stocks have provided investors with above-average returns over the past few years and hit all-time highs in 2020.

Assuming that you're interested in sharing such returns, here's how to invest in tech stocks — who the players are, and why they perform as they do.

Why invest in tech stocks?

Tech stocks generally carry more risk than other stocks, but they also promise significantly more growth. This has been the prevailing trend for several years now. Throughout much of the 21st century's historic bull market, tech stocks have been at the forefront of the rise, with the biggest tech stocks all outperforming the S&P 500 over the past five and 10 years.

In fact, the top five companies in the S&P 500 are all part of the tech sector:

These five stocks alone accounted for 18% of the total market capitalization of the S&P 500 at the start of 2020.

And speaking of this volatile year: Tech stocks even seem impervious to the coronavirus. "The tech sector has performed very strongly during the pandemic, recovering from the shock plunge in March 2020 to reach new record highs," says Susannah Streeter, a senior investment and market analyst with Hargreaves Lansdown.

There's a fundamental reason why tech stocks tend to attract more investor demand than other kinds of equities. Given that they look to the future and promise the delivery of new, exciting products — or new platforms which will help them secure dominant market positions — they're virtually synonymous with higher-than-average growth.

"The behavioral changes COVID-19 has brought about are only an acceleration of digital trends already sweeping through the economy. This has added to optimism that tech stocks, in particular stocks which have already seen big gains, will still be a safer longer-term bet," Streeter says.

Types of tech stocks for investment

The technology sector can be broken down into a variety of sub-sectors, each of which tends to be valued differently. Here are the main ones:

Software

This bracket usually refers to business and enterprise software, but it can also cover consumer software and apps. The most notable examples include Microsoft, Oracle, SAP, Salesforce, Adobe, and VMware, with Microsoft, Salesforce, and Adobe enjoying rises of nearly 50% or above from 2019-20.

Telecommunications

Telecom includes companies involved in telephone networks, broadband networks, and so on. The biggest examples include AT&T, Verizon, Nippon Telegraph & Telephone Corp., China Mobile, and Deutsche Telekom. Some of these, though, have witnessed negative growth over 2019-20.

Semiconductors

This category refers to stocks of companies that manufacture the semiconductors, chips, and other internal hardware used by computing devices. Notable examples include Intel, Taiwan Semiconductor Manufacturing Co., Qualcomm, Broadcom, Micron Technology, and Texas Instruments. Taiwan Semiconductor Manufacturing Co. and Qualcomm have both risen by over 60% in 2019-20, while Broadcom and Texas Instruments have risen by over 20%.

Tech hardware

This sub-sector covers companies that manufacture computers, consumer electronics, smart devices, and any other piece of digital hardware you might need in the 21st century (e.g. printers, routers). Apple, Samsung, Dell, Sony, Panasonic, HP, and Lenovo are included in this group, with Apple rising by just over 80% in 2019-20, and Sony rising by around 48%.

What are the 'best' tech stocks to invest in?

There's an elite group that many analysts exclusively refer to when they talk about "tech stocks." They're called FAANG: Facebook, Amazon, Apple, Netflix, and Google. Sometimes the group is extended to "FANGMAN" in order to include Microsoft and Nvidia, the pioneer in interactive graphics units (GPU) for computers and mobile devices.

FAANG and friends are the blue-chip stocks of the tech sector: large, with a track record of stable financial performance. In fact, for individual investors, the favorites all tend to be "Big Tech," the giants of the industry.

There are generally two important reasons as to why certain large-cap tech stocks may be a more worthy investment than others in the sector:

They exhibit strong growth, including revenue growth and stock price growth.
Their fundamentals are sound: They exhibit profitability and a sustainable balance of assets to liabilities, aka liquidity. Perhaps most importantly, their goods and services have solid market growth potential.

The combination of these two factors would indicate why you might invest in a FAANG stock like Amazon but not Tesla, for example. Amazon has grown aggressively over the past few months and years, but it also shows huge potential to dominate its sector for years to come.

Tesla, on the other hand, has seen its price grow impressively over a similar timeframe, but it's questionable as to whether it can dominate its market — electric cars — to an extent that would justify its high price-to-earnings ratio.

How to invest in tech stocks

The investor's first option is to buy individual tech stocks, which they can do through a growing range of investment apps and platforms, such as E*TRADE, Robinhood, Fidelity Go, SoFi Invest, Acorns, and Ellevest.

Investors can also invest in individual tech stocks via more traditional stockbrokers, although these are increasingly online now and usually have their own apps. These include Charles Schwab, TD Ameritrade, and Interactive Brokers.

The second option is to invest in tech stocks via an exchange-traded fund (ETF) or mutual fund. Examples of these include the Fidelity Select Technology Portfolio, Columbia Global Technology Growth Fund, Vanguard Information Technology ETF, and iShares Expanded Tech Sector ETF.

Since they invest in dozens, even hundreds of stocks, these funds will provide you with a broader exposure to the tech sector, and reduce the risks that come with investing only in a single company. And getting in requires smaller minimum investments — many of the leading tech stocks are extremely expensive, with share prices in the three and even four figures.

Drawbacks of tech stocks

Tech stocks come with their own dangers.

"Tech stocks ought to be considered as high-risk plays from an equity investor's perspective given that current valuations build in enormous future growth. This is reflected in the extremely high earnings multiples at which these stocks trade relative to other sectors of the equity market," says John Cronin, a financials analyst at Goodbody.

In other words, tech shares are often priced on the promise of their future earnings. Should those not materialize, the shares can't justify their high prices and they can go south — fast.

The sector has a reputation for volatility, too. Much of its association with violent price swings dates back to the turn of the 21st century. After a dramatic rise in the late 1990s, the bursting of the dot-com bubble in 2000 saw the value of many internet stocks collapse almost overnight.

However, the tech sector certainly isn't as dangerous for investors today, some analysts insist. More companies have built up reliable histories, and new products are built more on solid marketing data and research.

"The difference compared to 2000 is that many companies back then did not have (or had very little) revenue and they traded on the thought of a market for their services. This market has seen valuations compared to historical ranges rise dramatically but these companies are also delivering huge beats because of the pull forward of demand," says Brad Gastwirth, the chief technology strategist at Wedbush Securities.

The financial takeaway

While no one can guarantee that big tech stocks won't suffer volatility and dips, their growth may likely outweigh any losses in the long term. Investors looking to build a diversified portfolio should seriously consider adding them to their asset mix. They offer returns that aren't really matched by any other kind of stock.

If an investor wants the highest possible appreciation, they would do well to devote a segment of their holdings to tech stocks.