The stock market is the greatest creator of wealth there is. Over the long-run, no other investment comes close to the reliability of stocks when it comes to generating high returns. There are numerous investing strategies to choose from. Two of the most debated strategies are growth stocks vs. dividend stocks.
A strategy of investing in growth stocks is often recommended as the best for young investors in the accumulation phase. Dividend stocks are seen as companies that no longer have the means to grow. Therefore, their cash is paid out to shareholders in the form of a dividend instead of reinvested into the company. Growth stocks, on the other hand, provide the high returns that investors with a long investing horizon need.
Are these notions really true, though? Or have they just been repeated so often in investing circles that they’ve become an accepted truth?
FOMO and Growth Stocks
On the surface, the notion that growth stocks will outperform dividend stocks seems to make sense. If you only invest in well established companies that are paying a dividend, you’re going to miss out on the potentially huge gains from the next big thing. Think Microsoft of the 80s and 90s (59% annual return from 1986 through 1999), or Google from the 2000s (75% annual return from IPO in 2004 to pre-financial crisis in 2007).
From my reading up on the merits of the two strategies, this seems to be the biggest argument put forth by those in the growth stocks camp. There are two issues I see with this. First off, picking winners like Microsoft and Google is not as easy as it looks. Let’s take a look at a recent example to illustrate this.
Tesla has been a very popular growth stock over the last few years. Let’s say your timing was lucky and you bought in 2013 when the share price was $37. Just a year later in 2014, you would have realized a nice jump up to $270 per share. Since then, the stock has been up and down. Continuously dropping down to around $190, rebounding into the $260 range, then dropping again and rebounding again. Will it take off? Will the new Model X appeal enough to the average consumer for sales to take off? There’s no way to know. It’s exciting when you do hit the home run, but the strikeouts and weak popups in between can really damage your returns.
Secondly, timing the market is important. Many investors who pick individual stocks succumb to the trap of buying high and selling low. If you bought Tesla in August 2014 thinking it was the next big thing, you’d be disappointed with flat returns over the last 2.5 years. While the big hitters like Microsoft and Google seem obvious in hindsight, predicting them in real time is a little more difficult.
One of the pros of building a dividend portfolio is creating a passive income stream. Detractors of this strategy will point out the low yields offered today, given the high valuations of stocks. While true, a key strategy of the dividend investor is to invest in companies that have a track record of increasing dividends each year.
There are several lists that track such companies. The most well known is a list comprising of companies known as the Dividend Aristocrats. To make the list, a company must be on the S&P 500 and have a track record of increasing dividends every year for the past 25 years. These are large, blue chip companies from many industries that have very durable businesses and have shown earnings growth over a long period of time.
So while you may build an initial dividend stock portfolio that yields only 3%, over time that yield grows as companies increase their dividends. Take McDonald’s for instance, a member of the Dividend Aristocrats with increasing dividends for the last 40 years. If you bought McDonald’s stock ten years ago, you would have received an annual dividend of $1.50 per share. Today, the annual dividend is $3.61 per share. So while the current yield is just 2.85%, the yield on your initial investment is now 8.23% ($3.61 annual dividend / $43.87 share price on 1/1/07).
That’s the magic of compounding. Working to increase your returns while you sit back and do nothing.
Which is Best for the Long Haul?
I’ve outlined several benefits of dividend stock investing. But the question is, will it outperform growth stocks? Each camp is firmly entrenched in their views, but I haven’t found many studies using actual data to compare the two methods. Many have relegated a dividend stock strategy to an investor’s latter years when income is more important. Little credence seems to be given to dividend stocks as a worthy competitor to growth stocks in the accumulation phase.
I don’t have a dog in this fight as I have no ties to any one method. All I care about is which method will provide me with the highest returns and set me up the best for retirement. Be that through capital gains or dividends, it doesn’t matter to me.
In my next post, I will be using real historical data to compare the two methods over various time periods. Can dividend stocks keep up with or outpace growth stocks? It will be interesting to see which method comes out on top.
Readers, what are your views on dividend stocks vs. growth stocks? Which do you think provides better long-term performance? Do you have dividend stocks incorporated into your portfolio now or plan to in the future?