Dividend vs growth stocks: this is one of the most contentious investing battles. We often hear that dividend stocks are preferred when you are closer to retirement, while growth stocks are preferred when you are still young. Is there a truth behind this?
Are dividend stocks better than growth stocks?
Let us say there are two stocks:
- Stock A pays a 7% dividend, but its price declines by 1% per year
- Stock B pays no dividend and its price increases by 7% per year
Which one would you choose?
Sorry, it is a trick question. Although there looks like a clear winner here, Stock B (the growth stock), the correct answer depends on your circumstances which we will discuss shortly. Your investing objective, personal risk appetite, and investment horizon may affect your answer.
To be more informed about how dividend and growth stocks can fit into your investing objective, let us learn a bit more about the typical characteristics of these stocks.
Pros and Cons of Dividend Stocks
What is dividend investing?
Dividend investing is an investing strategy of buying and holding stocks that pay regular dividends. You will receive a consistent dividend income, usually quarterly or annually. You can either reinvest this dividend income to acquire even more dividend stocks or spend it for other expenses.
If your dividend income is more than your living expenses, congratulations, you are financially independent.
Dividend stocks pros
- Receive regular passive income in the form of dividend payout by holding the stock. The dividend payout date varies as it can be monthly, quarterly, or annually.
- Regardless of the market condition, whether up or down, you will still get the dividend payout regularly. However, note that this dividend payout is not guaranteed. The dividend payout comes from the ability of the business to generate profit, so only those with healthy fundamentals can consistently produce the dividend.
- Dividend stocks are usually less volatile. Many dividend stocks are for the more mature companies that are already profitable, so even in a bad market condition, they often can weather the market better. In addition to the regular dividend payout, this translates to a more stable price fluctuation.
Dividend stocks cons
- The dividend payout is not guaranteed. A dividend cut can happen when the company decides to reduce the dividend payout or even stops paying out the dividend. If the business can no longer generate profit, there is no dividend income to distribute to the shareholders.
- Dividend income is taxed at the year you receive that dividend. This taxation is usually not preferred because you will lose the compounding effect due to the yearly taxation.
- Some companies that pay dividends no longer know what to do with the extra cash and do not know how to grow their business anymore. This situation indicates the businesses have matured. Because the stage after maturity is the decline, we would like to caution you when investing in a company that pays a good dividend but is already in a ‘decline’ stage. If the company goes bust, you will lose your capital, and your dividend payout is probably not enough to cover your capital loss.
Pros and Cons of Growth Stocks
What is growth investing?
Growth investing is an investing strategy of buying and holding stocks of companies that are expected to grow faster than the market average. Your return will be in the form of stock price appreciation.
Growth stocks pros
- Instead of distributing their profit as a dividend payout, they reinvest the cash generated by the business to grow the company. Unlike paying out a dividend, immediately reinvesting the profits is not considered a taxable event.
- As long as you do not sell your growth stock, there is no capital gain tax. Yay!
- The growth rate of growth stocks can be higher than dividend stocks which may help you to beat the average market return.
- Growth stocks tend to outperform when the overall market is doing well. They usually appreciate more during good economic times.
Growth stocks cons
- You have to sell your stocks to realize your profit. Until sold, all profits are just paper gain that may disappear if the price moves in the other direction.
- Growth stocks tend to be more volatile and usually have more drawdown in a bear market. This volatility exposes you to higher risk as it may take longer for the price to appreciate back to the previous level. In the worst case, it may never come back again.
- The high growth rate is usually unsustainable for an extended period. All companies will eventually mature, and the growth rate will slow down.
- Many growth stocks are richly valued and priced for perfection. A miss on the projected performance may significantly impact the stock price.
Dividend vs Growth Stocks: Which should I choose?
Young Adults
For young adults with a longer time horizon, your objective is usually to grow your wealth.
If you want to grow your wealth, you want to maximize the total return of your investment (as long as it is within your risk appetite). We can define the Total Return = Price Appreciation/Depreciation + Dividend.
Total Return = Price Appreciation/Depreciation + Dividend
In the case of growth stocks, there are no dividends, so the total return is simply the price appreciation/depreciation. For dividend stocks, the total return is the price appreciation/depreciation + dividend.
Because growth stocks may not outperform dividend stocks over a long period, we recommend that you look at both growth and dividend stocks when deciding where to invest. Again, always keep in mind that you should optimize for the total return, regardless of whether it is a dividend or growth stock.
Near retirement or retired
For those near retirement or retired, dividend stocks look more attractive because of their relative stability (less price fluctuation). For those with a shorter horizon, your investing objective is usually to preserve wealth. Therefore, stability should be the foremost consideration.
We emphasize stability over a regular dividend payout because you can still receive regular payouts even with growth stocks. If a growth stock appreciates by 7% a year, you can cash out 7% of your holding every year to have a similar payout as a 7% dividend payout.
To prioritize stability, we recommend you look into dividend stocks of more mature companies in relatively resilient sectors, such as healthcare, consumer staples, etc. Your portfolio should be more defensive such that both the portfolio and the dividend income stay relatively stable even during a recessionary era. You will enjoy your retirement better without worrying about the market cycle 🙂
In summary, the choice of dividend vs growth stocks depends on your financial situation, risk profile, and investing horizon. There is no right or wrong answer, and most people hold a combination of both.
