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

Ask Stacy: Which Is Better — Dividend or Growth Stocks?
Photo (cc) by TerryJohnston

Hopefully you use stocks, or stock mutual funds, as part of your overall investment mix. If so, you’ll find this week’s question interesting.

Hi Stacy:

I have some stocks that I bought for gains, others that I bought because they have a high dividend. The growth stocks tend to go up, but don’t pay anything. The dividend stocks pay dividends, but don’t seem to go up much.

That leads me to wonder: Which is better? Will I make more in the long term by buying stocks that will increase or those that pay big dividends?

Thanks, and please do keep up the great work!
– David

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 growth stocks, as well as dividend stocks. The short answer as to which is better is neither: They’re both good. But let’s start this discussion with a quick look at stocks in general and dividend stocks in particular.

Stocks vs. bonds: owner vs. loaner

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 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. For a quick idea, see A Simple Way to Invest Your Retirement Savings.

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, the company will do what you’d do with extra income: Use it to make more. For example, a company might buy a competitor. It might build a new, more efficient factory, open locations overseas or start a new product line.

Companies that are focused on expansion are, logically enough, labeled growth companies. And as their business and profits expand, so (hopefully) does their stock price. Pretty exciting stuff if you’re a shareholder.

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, they simply can’t spend it all on expansion. What then? Well, they might start paying part of the profits to their shareholders. That money is called a dividend.

Traditionally, stocks that pay big dividends are more stable and less exciting. The company is mature. Their profits aren’t expanding as rapidly and thus their stock price isn’t either. Their sole source of excitement is the quarterly dividend check you get in the mail.

Which is better?

In an ideal world, you’ll find stocks that both pay dividends and go up. Example? Apple.Until a few years ago, Apple wasn’t paying dividends. It was keeping everything it made to fuel its expansion. Expand it did, and so did its stock price. Ten years ago, Apple was selling at $5 per share. As I write this, it’s selling for 25 times that: about $126. Pretty exciting.

By 2012, however, Apple was making so much money it couldn’t spend it all on expansion, so it started sending some of it out in the form of dividends. As of today, it’s paying $0.52 per share every three months, or $2.08 annually. That amounts to about 1.6 percent. ($2.08 divided by $126 = 1.65 percent). But its stock has also continued to go up. Since it started paying dividends three years ago, its stock is up about 50 percent.

So sometimes you can find both growth and dividend in one company. But even if your dividend stocks aren’t always this exciting, they’re nice to have for at least three reasons.

Dividends can limit the downside

Say you’ve got a stock that’s selling at $20 per share and it pays a $1 dividend. That’s a 5 percent return. ($1 divided by $20 equals 5 percent.) Now say the market goes down 50 percent. Will your stock fall that much? Not likely. Because the more it drops, the higher its yield becomes. The higher the yield, the more attractive the stock becomes to investors and the more likely they are to buy it, propping up the price.

For example, if our imaginary stock fell from $20 to $10, it would be paying an astronomical 10 percent dividend. ($1 divided by $10 equals 10 percent.) Long before it got that low, investors would be buying it to get that fat dividend, pushing the price up. Bottom line? As long as a dividend is safe, it puts a floor under the stock.

How do you know a dividend is safe? While there are no guarantees, if you invest in companies with a long history of stable or rising dividends, that’s a good sign.

Dividends can go up over time

As you can see from my online portfolio, I bought ConocoPhillips back in 2009 for a split-adjusted price of $31 per share. At that time, the company paid an annual dividend of $1.88 per share, so I was earning 6 percent. ($1.88 divided by $31 equals 6 percent.)

Fast forward six years, and the company has gradually raised its dividend to $2.92 per share. So instead of earning 6 percent, I’m now earning more than 9 percent. ($2.92 divided by $31 equals 9.4 percent.) That’s not a bad return, especially when you consider the stock has also more than doubled along the way. Imagine what my original investment will be paying 20 years from now.

You can use your dividends to buy more shares

I originally bought 300 shares of ConocoPhillips, but I now own 385. Where did those 85 shares come from? From reinvesting my dividends. Since ConocoPhillips is now trading around $62 per share, that’s more than $5,000 extra I’ve made, without really even noticing it.

Want growth? Buy both

Buying big growers like Apple is obviously an investor’s dream. But owning stocks that pay dividends is just as valid and is, in many cases, safer. In my opinion, both belong in your portfolio.

When I was a young financial adviser 30 years ago, I remember meeting with clients who were living entirely off their dividends. They didn’t accumulate their giant portfolio by being either rich or smart. They did it by investing dribs and drabs over long periods of time into the shares of high-quality, high-dividend-paying companies, then compounding their investment by reinvesting their dividends.

Don’t you want to be that kind of investor? I certainly do.

Got a question you’d like answered?

A great way to get answers to just about any money-related question is to head to our Forums. It’s the place where you can speak your mind, explore topics in-depth and, most important, post questions and get answers. It’s also where I look for questions to answer in this weekly column.

About me

I founded Money Talks News in 1991. I’ve earned a CPA (currently inactive), and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate. Got some time to kill? You can learn more about me here.

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