Which should you buy?
Lately, I’ve been seeing a lot of articles about how great dividend stocks are. I assume that this uptick in the love for dividend stocks is because they’re seen as safer investments than growth stocks, and investors are trying to find certainty in an uncertain marketplace. But what makes dividend stocks safer than growth stocks? In this post, we will break down the difference between dividend and growth stocks, what makes dividend stocks safer investments, and why you should skip dividend stocks even though they’re safer and go for growth stocks instead.
Dividend Stocks vs Growth Stocks
Dividend stocks are simply stocks that pay a dividend. A dividend is a percentage of a company’s profits that it pays out to its shareholders at regular intervals. Most companies that pay dividends tend to be better-established companies with large market shares and minimal opportunities for substantial growth. Growth companies, on the other hand, are usually newer and trying to seize market share. They have ample growth opportunities and reinvest all of their profits to try to continue growing at a rapid rate. Think Microsoft (dividend) vs Tesla (growth).
Why Are Dividend Stocks Safer than Growth Stocks?
The fact that companies who pay dividends are well established with a large market share makes dividend stocks less volatile than growth stocks. If you’re familiar with the golden rule of finance, the greater the risk the greater the expected or required return, then you know that volatility increases risk but it also increases your possible returns. Because of the higher volatility of growth stocks, their stock price will typically increase much faster than a dividend stock’s price. On the other hand, your risk of the company tanking and you losing all of your money is also higher with growth stocks.
The steady income stream dividend stocks provide also adds to their safety. Your return on investment from dividend stocks includes any increase in stock price, as well as the sum of the dividends you receive. Receiving dividend payments regularly means that you realize some of your returns in the form of cash payouts throughout the time you hold the investment. With growth stocks, your return comes solely from any increase in the stock price, and you don’t realize any returns until you sell the stock in the future.
Another reason dividend stocks are considered safer is because they usually aren’t as negatively affected by market declines. If the stock price does decline, you’ve also received some dividend payouts to help offset your losses. Since growth stocks don’t pay dividends, you have no dividend payments to help offset your losses if the stock price declines. However, dividend payments aren’t a guarantee. In a declining economy, a company may reduce or eliminate its dividend payouts, which usually causes the stock price to plummet, and creates substantial losses for investors.
The ability to mitigate your downside risk with dividend stocks does make them the overall safer investment choice over growth stocks. However, sometimes struggling companies will use dividends to try to cover up problems they’re having. When a company has operational issues but is still paying dividends, investors may assume everything is fine because they’re still receiving their dividend payouts. To avoid falling into this trap, look at a company’s performance vs its dividend yield. The dividend yield is the percentage of profits that the company pays out in dividends. Obviously, the higher the dividend yield, the more you’ll be paid in dividends, so you want to invest in companies with the highest dividend yields, right? Not necessarily.
When a company pays a dividend, it’s essentially saying that it can’t find anything to invest those profits in that would provide investors with a larger return than the dividends they’re receiving. For a well-established company with a large market share, having a high dividend yield isn’t a bad thing, but the company also needs to show some growth in the form of increased earnings, and enough free cash flow to pay their dividends. A company with stagnant or declining earnings, and/or limited free cash flow, which also has a high dividend yield should ring your alarm bells. If a company’s operational health is declining, that means that there ARE growth opportunities that could provide better returns for investors. The reason growth companies don’t pay dividends is because they reinvest all of their profits into opportunities to grow the business. If the overall health of a dividend company is declining, it should reinvest its profits more heavily into growth opportunities than into dividend payments. Investing in a declining company that isn’t investing in itself is a bad idea whether it has a high dividend yield or not.
Dividend stocks are also more affected by interest rate risk than growth stocks. Most people invest in dividend stocks for the income stream the dividends provide, so when interest rates rise Treasury bonds become an attractive substitute. This is because as interest rates rise, the return you receive from bonds also increases. Since bonds are considered safer investments than dividend stocks, as the return on bonds approaches the same return investors are receiving from their dividend stocks, they could reduce their risk but continue receiving the same return if they sell their dividend stocks and purchasing bonds instead.
Should You Invest in Dividend Stocks or Growth Stocks?
To make enough money from your dividend payments, you need to have A LOT of money invested. The average dividend yield is 2.2%, so even if you have $100k invested in dividend stocks, you’ll only make $2,200 per year off of dividend payments. That is not even close to enough passive income to live on.
To build a large amount of investments to reap the benefits of dividend payments, you should skip the dividend stocks and invest in growth stocks while you’re young. A young person can take on much more risk because they have plenty of time to make up any losses before they need the money later in life during retirement. By investing heavily in growth stocks when you’re young, you can grow your investments much more substantially, and as you age, you can transition to safer investments like dividend stocks. Just make sure to keep a well-diversified portfolio that also has other less risky investments in it, like bonds that provide many of the same benefits of dividend stocks. This will reduce the overall risk of your portfolio, but also allow the growth stocks to work their magic and lead you down the path to becoming a rich bitch!
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