Ask Stacy: Which Is Better – Dividend or Growth Stocks?

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This is an interesting question I recently received from a beginning investor…

Hi Stacy:

Can’t thank you enough for all of the helpful articles on MTN that I read DAILY, on the site and via Twitter! I’ve become a much better saver and will hopefully become a better investor as well.

Last year, I had written to you about how I’m starting to invest in the market, but I feared investing in the unfamiliar. Well, I’ve done some more research and am happy to say that I’ve diversified my portfolio somewhat. I have not only shares in tech but other sectors as well – many that offer dividends (hey, it beats my 0.8 percent-interest savings account). I certainly feel I have less of my eggs in one basket.

Apple has been a huge success on my portfolio. I could only afford a few shares, but the gains have been enormous. I’ve mentally labeled it as part of my “growth stocks group.” On the other hand, I have other shares that have neither gone dramatically up or down – but I didn’t really mind since those provided dividends, so I still make gains. Those I’m mentally labeled as “less volatile with some gains group.” I know, very scientific. But… I’ve recently read that there’s rumor that Apple may soon offer dividends, or at least the board is pondering it.

That leads me to wonder: What happens to a company’s shares once it starts providing dividends? Does it change the nature of the investment dramatically? Should I no longer expect dramatic growth? Or I am completely comparing Apples (pardon the pun) and oranges (aka Microsoft – non-volatile, dividends, but hasn’t really grown)?

Thanks again, and please do keep up the great work!

– Erin

Thanks for the kind words, Erin!

Congratulations on spreading your wings and looking outside traditional savings accounts in order to earn more. And further kudos for doing the research necessary to select appropriate investments.

I also own Apple. In fact, as I mentioned in this Ask Stacy column last year, Apple has by far been the best investment I’ve ever made. Believe it or not, I bought Apple more than 10 years ago at a split-adjusted price of about $8 a share. It closed recently at more than $535. (You won’t see that one in my public portfolio because it’s in my retirement account.)

Just over a week ago, in a story called The Single Best Tip to Beat High Gas Prices, I also mentioned a dividend-paying stock that I own: ConocoPhillips. The point of that article was that if you want to beat high gas prices, own a few shares in the companies that benefit from them.

Let’s answer Erin’s question – and maybe some you’ve had – with a quick discussion of stocks in general and dividend stocks in particular.

Why invest in stocks?

While it may appear that there are hundreds of ways to invest, when you boil it down, there are only two: You can either be an owner or a loaner.

If you have money in the bank, you’re a loaner. You’re loaning money to the bank in exchange for some interest, as well as a guarantee that at some point in the future, you’ll be reunited with your money.

If you invest in stocks, you’re an owner. Your stock investment represents ownership in a small part of a business. As with owning any business, there are no guarantees. Your reward comes when your share of the company becomes more valuable and you sell it to someone else. What makes it more valuable? Simple. The company is making more money.

Since ownership investments have more risk, they offer greater rewards. This makes sense: After all, if the stock market didn’t return more over time than risk-free investments like Treasury bills or an insured bank account, nobody would put money there. Over long periods of time, ownership investments like stocks typically earn about double the return of loanership investments like bank accounts.

That being said, because of their longer-term, more volatile and riskier nature, it’s dumb to put all your eggs into ownership baskets. Everyone needs both – safe but boring loaner stuff, and more exciting but riskier owner stuff. How much to put in each depends on lots of things, from your age to your risk tolerance, but for a quick idea see Manage Your 401(k) in 1 Minute.

Dividend vs. growth stocks

Hopefully, any company you invest in will make money. But what will it do with the money it makes? In the beginning stages of a company’s lifespan, it will do exactly what you did with the first extra money you made: save it for a rainy day. When it’s built an adequate emergency fund, however, the company will also do what you’d do if you ran a successful business – start looking for ways to expand and make even more. For example, it might buy a competitor. It might build a new, more efficient factory, or start opening locations overseas.

Companies that reinvest their profits to expand are, logically enough, labeled growth companies. But what about companies that don’t need all the money they’re making to expand? Maybe they’ve been around so long they’ve already got a location on every corner. Or maybe they’re making so much money, there simply aren’t enough options for spending on expansion. What then? Well, they might start paying out at least part of the profits to their owners – their shareholders. The money they pay out is called a dividend.

Traditionally, stocks that pay dividends are more stable and less exciting. The company is “mature.” Their profits aren’t expanding rapidly and thus their stock price isn’t going up rapidly either.

The two stocks mentioned above offer textbook examples of each. ConocoPhillips is an oil company that’s been around for a long time. They invest part of their profits into finding new oil and buying new equipment, but they’re making so much, they also pay dividends to their shareholders. As I said in The Single Best Tip to Beat High Gas Prices, ConocoPhillips pays $2.64 in dividends annually. Since the stock is going for around $75 a share, that means they’re paying a 3.5 percent dividend ($2.64 divided by $75 = 3.52 percent.)

Apple, on the other hand, has been focused on developing new products and more effectively marketing the products they have. To do that, they’ve kept all the money they’ve made – they’ve never paid a dividend. But as their sales have accelerated, so has their stock price. Going from $8 to $500 is a lot more fun than collecting a 3 percent dividend.

Which is better?

Now I’ll finally address Erin’s question, which, in case you’ve forgotten, was: “What happens to a company’s shares once it does start providing dividends? Does it change the nature of the investment dramatically? Should I no longer expect dramatic growth?”

Erin’s asking this because there’s been a lot of talk recently that Apple is likely to start paying a dividend. They’ve accumulated so much cash – nearly $100 billion – there’s simply no way to use it all to grow their business. Erin’s concern is that once Apple starts paying a dividend, it changes from a growth stock that goes up in value to a more mature, more boring, and potentially less lucrative dividend stock.

Not to worry, Erin. While it’s true that Apple may be forced to pay a dividend by virtue of its stupendous cash hoard, that’s unlikely to render it stagnant or boring. Apple still has room to grow. They’ve just made so much money, they simply can’t spend it all.

Bottom line? While there’s a rule of thumb that dividend stocks don’t go up as much or as rapidly as growth stocks, it’s just a rule of thumb. If Apple continues to be so popular that people get tattooed with their logo (see photo above), it will continue to be an exciting investment, whether or not it pays a dividend.

Got a question regarding anything having to do with money? Drop me a line and I’ll try to answer it!

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