If you are new to investing or want to become a savvier investor, it’s important to learn the difference between different types of investments and what these investments can do for your portfolio. The more you know about investing, the better-informed your investment decisions will be, so you’ll want to start by understanding the basics and clearing up whatever confusion you have as questions arise.
A common point of confusion for novice and burgeoning investors is sorting out the differences between dividend versus growth investments and determining which to choose.
Rather than buying individual stocks, you may want to consider mutual funds that are focused on either a growth or dividend strategy, but you’ll need to understand the fundamental aspects of each type of investment first.
With dividend investments, the excess return is declared and shared with investors while the profit excess is withdrawn as dividends. In growth model investing, the excess return is reinvested in the corporation and the only way profits are materialized is when stock is redeemed or the stock is sold.
Each type of investment has advantages and disadvantages, which depends on the investor’s individual goals, financial circumstances, and investment horizon.
Dividend Investing
Dividend investing involves buying stocks that pay dividends. The company pays its shareholders a distribution of a proportion of profits. This offers investors a chance to benefit from a stream of income in addition to the growth in the market value of the stock.
Some of the advantages of dividend stocks are that they tend to outperform growth stocks, offer consistent cash flow at regular intervals, and because stocks that offer dividends typically indicate that a company is financially healthy enough to pay shareholders cash, the investment can be less risky. Having an obligation to pay out dividends typically forces management to make disciplined decisions about capital allocation.
Another potential benefit is that recent changes in the tax law allow for some individuals to receive dividend payouts federal income tax-free on qualified dividends. If your income does not exceed the set limit, a dollar you get from a dividend could end up being more valuable than a dollar you earn from taxed wages.
That said, investors should seek safety by looking carefully at the payout ratio and looking for companies with stable enough cash flow and income to cover the dividend payouts comfortably.
A good strategy may involve focusing on a high-dividend yield, which results in large cash flow income now, or a high-dividend growth rate, which results in lower-than-average dividends now with the expectation of quick company growth during a rapid expansion period and per-share dividend growth over the next five to ten years.
Generally speaking, dividend investing is recommended for investors with a shorter time horizon looking for more liquidity.
Growth Investing
Unlike dividend investing, with growth stocks, money remains invested in the company and is not paid out in periodic intervals. Instead, all excess return generated gets reinvested back into the stock itself. In other words, with growth investing profits are only materialized when the stock is sold or redeemed.
When you are investing in growth stocks, you are banking on future projections and the possibility of company growth and resulting asset value growth. Without focusing on paying dividends to investors, the expectation is that management is focused on finding growth opportunities within the company in which to invest its retained earnings. Whereas dividend-paying companies are controlling expenditures, growth companies are spending on growth.
A growth investment model is a strategy based on getting a return over a longer period of time, so it is generally best for someone with a longer time horizon who does not need as much liquidity.
Conclusion
Now that you know the difference between a growth stock and dividend stock, you might be wondering which is better. The answer depends on factors including the return you’re looking to get, your individual goals, financial circumstances, risk preference, and investment horizon. No single option is perfect for every investor.
It’s best to examine each investment’s attributes and avoid those that don’t suit your specific requirements for income from cash payout or holding for long term growth. If you are looking to create wealth and have a longer time horizon, staying invested in growth will enable you to enjoy longer returns. But if you are looking for a more immediate return and steady cash flow, dividend investing could be the best choice for you.
Kevin Stoddard is a LPL Financial Advisor with Stoddard Financial in Quincy, Massachusetts. Stoddard helps clients throughout New England to identify, plan, and execute strategies designed for securing their desired financial future. With their Financial Wellness @ Work program, they engage, educate, and empower employees by helping them to understand and appreciate the value of their benefits package.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
All investing involves risk including loss of principal.
No strategy ensures success or protects against loss.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Stock investing involves risk including loss of principal.
The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time
This material was prepared by Crystal Marketing Solutions, LLC, and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate and is intended merely for educational purposes, not as advice.
