The stock market is a fantastic place to grow wealth. It is far more accessible than most people think, has no ceiling for growth, and allows your wealth to compound over time. But it can be difficult to pick options: dividend vs. growth stocks, individual companies vs. funds, and different sectors.
These options can feel overwhelming, stopping many people from ever investing. So let’s distill this problem down to one question at a time.
This post will compare dividend vs. growth stocks
If you are interested in an overview of the stock market as a whole, check out my post on stock market basics.
The most basic goal of the stock market is to sell shares of companies for more than you paid for them. This net difference is your gain or loss, depending on whether you sold for more or less than you paid.
A company that is focused on making its investors in this manner is a growth stock. Examples of growth stocks include Apple (AAPL), Visa (V), and Microsoft (MSFT). These companies pay a dividend of around .7%, instead focusing on growing their companies and subsequently their stock price.
Alternatively, a company may utilize more of its profits to reward its shareholders for holding its stock. These payouts are called dividends, and these are dividend stocks. Examples of dividend stocks are AT&T (T), Chevron (CVX), and IBM (IBM). These companies pay at least a 3 or 4% dividend.
Both of these kinds of stocks are attempts by the underlying company to generate as much value as possible. This value benefits both themselves and shareholders.
Both of these methods have pros and cons to them. Please consider all factors before investing in either kind of stock.
Return on Investment
In general, if an otherwise solid company decides to pay a low dividend, then it believes in its own ability to generate returns on investments.
Imagine that you are the company. You have $100,000 in additional profits this month to spend as you see fit. You could either pay that out in dividends to reward loyal shareholders or buy that new machine you have been eyeing.
Though you know that the new machine won’t result in immediate increases in revenue, once it is integrated into daily production, you know it will result in 10% higher profits. You believe in the ability of your company to use those funds in such a way that it will improve your business. This profit increase will be felt by shareholders too as the profit margins increase over time.
Growth-focused companies have this mindset. If the company didn’t believe in its own abilities, it may decide to pay out a dividend instead.
When you purchase a share of a company and watch it rise, you have not made any money yet. You have simply gained the opportunity to make money by selling it for more than you paid. The process of making money by selling shares is called realizing your gains. Alternatively, selling for less than you paid is called realizing your losses. These terms are also often referred to as capital gains or capital losses.
With growth stocks, you don’t have to realize your gains or losses until you see fit. You could hold Visa for as long as you wanted, or at least until the company goes bankrupt. All the while, you haven’t technically made any money.
The key is that until you realize your gains, you have not made any profits that can be taxed. The IRS cannot tax you until you realize your gains by selling your shares.
This is a powerful advantage as you can defer your taxes until the tax rate is lower or you have a lower income. If you retire from your $70,000/year job and realize $40,000 in gains, you will pay far less in taxes than if you had realized your gains while you were still working. From the IRS’ point of view, you would have made $110,000 that year.
An additional benefit is that realizing losses can be powerful too. You are able to realize losses and use those losses to offset income by up to $3,000/year. This reduces your taxable income, thus lowering your taxes. If you are interested in this advantage, read more about it here.
Taxes on capital gains are dependent on how long you held the shares prior to selling. Long-term capital gains taxes apply when you have held the asset for longer than one year. As opposed to short-term capital gains taxes which apply to assets held for less than one year.
The difference between these taxes can easily be 10%, depending on how much money you made in capital gains. It certainly benefits you to hold your assets for longer than a year as long as it is a solid company.
Owning growth stocks allows you to avoid these short-term capital gains. You are able to control when you realize your gains.
If a growth company with little or no dividend gets hit by a market downturn, it will have a very large effect on your portfolio. The only option you have is to wait it out and put more money into it if you’re able.
This does have the benefit of averaging down your cost, but it requires you to put more of your own hard-earned funds into it.
You Have to Deposit to Grow Your Ownership
This may sound like an obvious one, but with growth stocks, you have to deposit funds to increase your stake in the company. No matter whether the stock rises or falls, you still own the same number of shares. The only way to increase your ownership of the company is to deposit money from outside income or sell other stocks and purchase more shares.
This is a downside that is more impactful when you learn more about dividend stocks. Up front, it seems reasonable, and it is. But it isn’t the optimal situation.
Dividend Stocks Still Grow
We have to remember that companies with dividend stocks still want their stock to grow. They are in the stock market for rising valuation, not just to pay shareholders a dividend.
This growth may not be as drastic as a growth company, but if it’s a good company it should still be there.
In general, the stock’s growth may be offset by the dividend that it pays out. For example, let’s assume that the average market return is 10%. If a company pays a 4% dividend, then a 6% annual growth isn’t too bad since you got the remainder of the returns in dividends.
Be wary of dividend stocks with constant sideways movement. All stocks go through periods where they struggle to grow. But a stock that doesn’t seem to have the ability to grow will only give you returns as large as its dividend.
Most large companies that pay a dividend won’t lower their dividend unless they have very severe concerns. This includes during a market downturn. This means that if you were getting paid a $10 dividend before a downturn, you will receive the same size dividend during a downturn.
There are two keys to the importance of this phenomenon. The first is that as the share price goes down if the dividend amount stays the same, the dividend percentage actually increases. You are now earning a larger dividend yield than before the downturn. For example, a $4 dividend on a $100 stock goes from 4% to 8% if the share price falls to $50. This higher yield also means you are increasing your ownership of the company. Increasing ownership should always be a goal for companies you believe in.
The second key benefit is that by receiving dividends during a downturn, you are automatically averaging down your cost. If you paid $100 for a stock that is now worth $50 and you are reinvesting your dividends, then those dividends are purchasing additional shares at that lower price. Now, the average price you have paid for those shares is lower. Averaging cost down is always beneficial, but especially for having a powerful recovery when the stock goes back up.
Passively Dollar Cost Average
I cover dollar cost averaging in my beginner’s guide to the stock market under the section “One of the Most Important Rules of Investing (IMO)”.
A quick overview of it is that dollar cost averaging is when you purchase portions of shares on a set frequency regardless of market behavior to average out your cost and follow the trend of the stock. Dollar cost averaging has proven to be one of if not the most effective methods of investing.
I am a massive fan of using automation to dollar cost average. Usually, this involves setting up automatic investments, covered more in this post.
However, dividends are a fantastic second form of dollar cost averaging. When you reinvest a dividend, you are purchasing a small portion of additional shares of a company. Plus, those dividends are paid out on a regular basis. Thus, you are automatically dollar cost averaging just by reinvesting your dividends.
I love realizing things are much simpler than they are made out to be. Dividends are one of those things that make success in the market seem far simpler than we are taught to believe.
Dividend Income Tax
Taxes on dividends is a complicated situation. There are two kinds of dividends: ordinary and qualified.
Ordinary dividends are dividends received soon after the purchase of a given stock or received from most international companies. These dividends are taxed as ordinary income, just as if you got a bonus from work. This means that you will pay a significant income tax depending on your tax bracket.
Qualified dividends are dividends received from a domestic company at least a few months after the purchase of that company. If you want to read more about them, check out this post by Fidelity. The gist of it is that these dividends are taxed at the long-term capital gains rate. This can be a very low rate, even as low as 0%.
Regardless of what kind of dividend is received, you will be taxed on those dividends that year. The downside to this is that you get less control over when you are taxed. Let’s run through a scenario.
Imagine you purchase $100 shares of two stocks: one growth, and one dividend. If the growth stock grows by 10% over one year, and you don’t pay any taxes yet.
In the same year, your dividend stock has grown by 7% and paid 3% in dividends. Though you still made 10% in gains, you were also taxed on those dividends. This may lower your net gains to 9.5% or so. That isn’t a monumental difference, but it will make a difference over the long term.
Less for Reinvestment
For a company to consistently grow in the long run, it needs to invest in itself. A sandwich shop needs to invest in faster food slicers. A manufacturing plant needs to invest in more advanced machinery. These reinvestments back into the company allow it to take itself to the next level to increase profits.
By definition, a dividend requires a company to take some of its profits and pay back shareholders. This means that there are now fewer profits available for reinvestment in the company.
A company focusing on dividends can absolutely grow. It will just have less money to play around with to find what its next big step is.
Of course, a lot of this post assumes everything is equal and that gains are identical. In the real world, this is never the case. A dividend stock may grow well in addition to paying a high dividend, making it a better deal. Or a growth stock may invest in just the right sector of its company and rise by 20%. You just never know.
There is no clear winner between the two kinds of stocks. They both bring their own advantages and disadvantages. A lot of it depends on other factors around the underlying company. A bad company is a bad pick, regardless of whether they operate on dividends or growth.
For myself, I want a mix of the two. I do certainly prefer to have a solid dividend to offer its unique benefits. Maybe a dividend yield of around 2-3%. But still, a company that knows how to generate a return on investments in itself. I have felt most confident in this “best of both worlds” approach.
If you disagree and have your own methods of investing or feel like I missed something, let me know down below! I love to have discourse with people on these kinds of topics so please feel free to chime in. I will talk with you next time.
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