Dividend Investing vs. Growth Investing

Fajasy
Updated: September 5, 2019

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This article on dividend investing vs. growth investing attempts to compare both strategies and provide practical guidance to investors. By the end of this article, you'll have a better understanding of both of these investment strategies and will be able to select one, or both, depending on you financial situation and investment goals.

Growth Investing

Growth investing focuses on the capital appreciation of a stock's price. As a growth investor, you will only purchase a stock if you are confident that it will increase in price significantly overtime. This purchase may be due to a company's current "low" stock price, its financials, market trends, or simply because of the company's competitive advantage.

Growth investors and their strategies vary, with some holding a stock for the short-term (1-2 years or less), and others buying and holding a stock for 20+ years, without ever selling. These investors only hope for significant amounts of capital appreciation and do not really care about any dividend payments.

For example, let's say you purchased one stock at $100. You purchased this stock because of an upcoming company announcement in the next few days. Fortunately for you, positive news comes out, the company is expected to generate even more revenue, and the stock price skyrockets to $150 within a couple of weeks. You then sell your one share for $150 and profit $50 based on this speculation.

So, with growth investing, you're more subject to unrealized gains or losses. For example, let's say you invested $1000 into a stock and it grew to $5000 over a 5-year period. Unfortunately, the day before you decide to sell your shares a market crash happens and your $5000 becomes $3500 in just one day.

This $5000 that it was at previously is what's called as "unrealized gains." Essentially, this means that you don't actually receive the gains from the stock market until you actually sell your shares and receive money from the stock you've invested in. So, this is something you should always be aware of as a growth investor.

Often times, if a company does not pay a dividend, the first reason is simply because it's not feasible for the company, due to its financial situation or current market situation. The second reason is because companies believe they have adequate room for growth in the future and do not want to pay dividends, as it will limit their growth potential. In other words, most growth stocks do not pay dividends as they are less established and have more room for growth than more established companies, which pay dividends more often.

One example of this is Okta (OKTA), a cloud software company that manages and secures user authentication into modern applications. This company was founded in 2009 and only became available for the public to trade in 2017.

Because Okta is in its very early stages of growth and is still innovating, Okta does not pay dividends and will likely not do so for the next few decades, if ever.

In short, here are the circumstances where being a growth investor makes sense:

  • Young age and/or risk-prone investor.
  • Smaller amounts of capital.
  • Possible higher returns, outperforming dividend-paying stocks.
  • No taxes until gains are realized. This is more advantageous for long-term growth investors and tax-advantaged accounts.
  • Belief in disruptive and/or innovative industries/companies.

So, if you are a younger investor who can take on more risk, or if you're an individual with fewer responsibilities, investing primarily in growth stocks would make sense. Moreover, if you're investing in a stock because you believe it will disrupt the industry, or because the company is innovative (i.e. Apple), then this may net you more in gains than a good dividend-paying stock.

Finally, especially for long-term growth investors, there is a substantial tax advantage here, as dividend-investors have to pay the qualified dividend tax rate (more for REIT dividends) on any dividends they receive. Growth investors, on the other hand, only pay taxes when they realize their gains. Moreover, if these gains are realized in a tax-advantaged account, such as a Roth IRA, then you will not have to pay any taxes on these gains.

Dividend Investing

When you invest in dividend stocks you are focusing on generating income, or a consistent cash flow stream. Therefore, dividend investors are earning cash regardless of whether a stock goes up or down. This is obviously different than growth investors, as growth investors are focused on capital appreciation rather than cash flow.

Dividend stocks are typically more established and focus a lot of their attention towards their existing operations. This does not mean dividend stocks are not growing (as the dividend growth investment strategy requires). What this really means, is that dividend-paying companies are large enough that they can take a portion of their earnings and pay it forward to their shareholders.

The Coca-Cola Company (KO) is a good example of this. Coca-Cola is a dividend-paying stock that likely does not have as much as room to grow as Amazon (AMZN), for example, but has really expanded throughout the world and is a more older and established company.

Furthermore, although dividends are never guaranteed, there are dozens of companies and several measures you can follow to ensure you're investing in a dividend-paying company that will continue to pay out dividends for the long-term.

So, if you purchase $1000 worth of a dividend stock, this price may go up or down. Regardless if it goes up or down, you'll still be receiving cash quarterly (more or less) ever year. This cash component should also grow and compound on itself as you reinvest the dividends you receive until you sell your shares or the company stops paying dividends.

The best dividend-paying companies will also continue to pay out dividends through recessions, although some will cut or reduce the dividend they payout. Here are four reasons why this may be the case:

  1. Dividend investors tend to hold onto their stocks for the long-term.
  2. Dividend-paying companies are more established and do not crash as hard as growth stocks.
  3. Dividend-paying companies will have an easier time rebounding from a market crash than growth stocks.
  4. Dividend yields are at a higher starting yield and lower price (usually) during a prolonged market crash.

To elaborate, most dividend investors are primarily investing for the cash flow, not capital appreciation in the market like a growth investor is, although the capital appreciation is a nice added bonus. Therefore, they do not worry too much when their stock falls in price, but rather see it as a good thing.

This is because dividend players are more stable and do not crash as hard, in general, as growth stock companies. More often than not, dividend-paying companies are blue-chip stocks with multinational brands, and are usually well-diversified within their industry. Growth stocks, on the other hand, are generally more volatile, risky, and may be reliant on just a small line of products/services.

The chart below compares the S&P 500 Dividend Aristocrats, or a list of companies that have consistently grown their dividend for the past 25 years, to the performance of the S&P 500. As you can see, dividend aristocrats have done well to outperform the S&P 500.

Good dividend stocks, such as those in the dividend aristocrats list, will therefore correct themselves in capital appreciation after a market downturn, and will have an easier time rebounding than growth stocks which may never recover after a severe recession.

The chart below demonstrates this fact as well, with dividend players having smaller amounts of volatility in comparison to "non-dividend payers," where growth-stocks are considered.

Another reason why market crashes are not as worrying for dividend investors, is because the dividend yield for dividend-paying companies will be at a higher starting yield.

Dividend yield = Annual dividend / Current stock price

Moreover, these dividend stock prices will likely be at discounted buying prices due to the market crash. So, with this lower-value purchase price and higher starting dividend yield, one could receive a better "yield on cost" over their years of holding the stock when compared to purchasing a dividend-paying stock during a bullish market.

In short, here are the circumstances where being a dividend investor makes sense:

  • Seeking cash flow or to invest in more established companies.
  • Older age and/or more risk-averse.
  • Larger amounts of capital.
  • Investors who have a goal to retire early.

This is a rather self-explanatory list, but dividend investing is one of the best long-term investment strategies you can utilize if you are seeking a relatively consistent stream of cash flow. It's also the better choice if you are more risk-averse, have more to invest to actually see the returns of dividends, or if you aim to retire early from the dividends you receive.

Growth Investing or Dividend Investing?

Now that you know the pros and cons of both growth and dividend investing, and also which strategy is more befitting to your personal circumstance, there are a couple questions that still need to be addressed.

The first, is how has the performance of these two strategies compared overtime? The second, is how much should the average investor allocate to each of these strategies?

Performance Comparison and Dividend Yields

To begin, let's start off with the historical performances and facts.

The chart above illustrates just how much dividends have played a role in an investor's returns. As you can see, 42% of the S&P 500 returns in the past ~90 years have come from dividend stocks. On the other hand, 58% of the S&P returns in the past ~90 years have come from growth stocks. This makes sense given the nature of dividends and the volatility of the stock market.

However, this does not mean that dividend stock returns have been inferior to growth stocks as it fluctuates heavily every decade. In other words, different markets favor different types of investing, and a 42% total return is quite substantial from just dividends. Regardless, growth stocks may have the slight advantage here, especially in the last 10 years.

The chart above compares the performance of the top, middle, and lower dividend payers and the non-dividend payers. As you can see, over the long-term (since 1927), the larger players have performed the best by quite a significant margin. This "Non-Payers" category is also where growth stocks would fit into.

The graph above further supports than dividend payers have dominated the performance of non-dividend payers over the long-term. So, although past performance does not guarantee future turns, in the long-term perspective, investing in dividend-paying companies may provide you with a better return.

One thing to note here, is that dividend yielding stocks may under-perform the overall stock market when interest rates are rising.

This is because rising interest rates may impact how much cash a company has to pay to its shareholders (in the form of dividends), especially for debt-heavy companies. Another reason, is because Treasury bills and certificates of deposits (CDs), for example, begin to look more attractive to investors when their risk-free yields are the same as the current dividend players' yields.

Ultimately, this leads to an opportunity cost situation where investors may completely switch to investing in a 10-year bond with a yield of 5%, instead of a dividend-paying company with a 5% yield.

Dividend and Growth Investing Allocations

What you tend to find is that the highest short-term returns for growth stocks are typically with small-cap stocks. These small-cap stocks may be best to buy after a correction or crash in the stock market. This is because these stocks are typically very volatile, and in general, are heavily reliant on the overall market sentiment and movement.

On the other hand, mid to large-cap growth stocks are typically a better and safer bet for long-term investing. Below is a comparison chart of Vanguard's large-cap (VLCAX), mid-cap (VIMAX), and small-cap (VSMAX) indexes and their performance over the past 5 years.

Dividend stocks should also be held and accumulated through corrections and crashes, but the price at which you purchase these stocks does not matter as much. This is because dividend stocks are typically less volatile and tend to gain in capital appreciation as companies continue to grow their dividends. Furthermore, in many cases, you'll be investing in a dividend-paying company because of its dividend, not because of its capital appreciation potential.

So, in almost all cases, it makes sense to have both dividend and growth stocks in your portfolio. The percentages you determine should completely depend on your current situation, such as your age, income level, and what your goals are.

For example, if I were 24, made $60,000 a year, and expected to retire after 60, my portfolio would consist largely of small, medium, and large growth stocks. If I made even more per year, I would allocate more to dividend stocks.

On the other hand, if I were 50, made $300,000 a year, and also expected to retire in 10 years, my portfolio would consist largely of dividend stocks. Doing this would more than likely lead to a safer retirement, and you can really see the impact of dividend investing with larger amounts of capital.

In short, find which investment strategy you want to prioritize according to your personal financial situation. The right answer may even be to ignore both and to just invest passively in an index fund. Again, this all depends on your financial situation and what your goals are in life!

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