What’s the best choice between growth stocks vs. dividend stocks? The answer depends on which strategy helps you to best achieve you investment objectives.
One of the biggest financial mistakes I ever made was selling a stock.
In 2006, I bought 40 shares of Apple (AAPL) for about $58 a share. I called myself a long-term investor at the time because I had owned dividend stocks like Chevron and Coca-Cola for more than a decade.
But I was also happy to make a quick buck from trading.
There were rumors of an Apple mobile phone in the pipeline in 2006, but most people thought it would be a glorified iPod that let friends talk and text.
Big deal, right?
After six months, my position increased by 25%, so I sold in October 2006 for a tidy $500 trading profit.
You know the next part of the story.
In January 2007, Steve Jobs announced the 1st generation iPhone, a once in a lifetime innovation that changed the way we live.
If I had continued to hold all of my original shares, I’d own 1120 shares today at a cost basis of around $2 per share.
Those shares would be worth about $170,000 as I write this (Apple at $152, August 2021) — a ~7500% gain on my original investment.
All I had to do was nothing.
Now, don’t cry for me. Six years after the iPhone announcement in 2013, I bought another 16 shares of Apple, which I’ve held since then.
Those 16 shares split twice into 448 shares that cost me $16.82, now worth more than $68,000 today — a nearly 800% return.
And Apple has paid a dividend since 2012, adding another $2,500.
Years of Oversight
I’ve followed the stock market for decades. During that time, I’ve mostly focused on owning established companies with steady cash flows.
Many of these businesses pay and grow their dividends. I’ve always liked dividend-focused investing because dividend payments are a reliable source of passive income.
As the stock market fluctuates, a diversified portfolio of dividends pays a predictable income stream, which grows each year.
However, since I started following the market, I’ve watched several growth stocks rise by more than 1,000%.
- Amazon up 20,000%+ since 2002
- Disney up 6,000+ since 2002
- Netflix up 22,000%+ since late 2004
- Nvidia up 8,000%+ since 2005
- Tesla up 6,000%+ since 2012
- Shopify up 3,000%+ since July 2016
Source: Motley Fool as of 10/18/2020.
These aren’t unknown companies — I’ve been a customer of most of these for many years.
But as investments, they were hidden to me in plain sight, disguised as overpriced, overhyped stocks.
How else could I miss investing in Netflix, a service I was using in 2004?
A few years ago, I decided to stop limiting my universe of equity investments to index funds and dividend stocks and started buying growth stocks.
There are lots of profitable ways to invest. You’ll hear strong advocates of specific investment strategies, but don’t let them convince you there’s only one best way. It depends.
The right investment for you depends on your knowledge, comfort zone, willingness to learn, and risk tolerance.
Whatever strategy empowers you to reach your investment objectives is the best for you. It could be real estate, options trading, fixed income, or something else.
I like stocks.
As such, I invest in growth stocks, dividend stocks, an index funds — each for different reasons.
The chosen investment strategy isn’t as important as your savings rate (percentage of take-home pay you retain), diversification (“free lunch”), and long-term investment horizon.
Those are your investing superpowers because you control them. They impact your ability to grow wealth more than investing strategy, especially early on.
I’ve allocated the bulk of my retirement money to market index funds. I use these funds to “set and forget” most of my retirement savings and keep fees to a minimum.
Most novice and intermediate investors should focus on stock market index funds first. It’s the simplest investment strategy out there and has solid returns and low fees.
You’ll enjoy market returns without having to learn how to evaluate individual stocks, which can be tricky and takes time.
About 10% of my invested assets are in bond index funds, 85% in equities (mostly index funds and individual stocks), and the rest in cash.
I’ve also owned two managed stock mutual funds dating back to my first job in 1998. One is up 950% (Fidelity OTC), the other 500% (Fidelity Contrafund).
I use dividend stocks to generate passive income, which will eventually cover most of my retirement expenses. I look for stocks with a long history of paying and increasing the dividends above the inflation rate. Then focus on valuation and dividend safety.
I currently earn about $780 per month, on average, from dividend stocks. The number grows nearly every month whether I invest more money or not because most dividend companies I own increase their dividends every year.
Speculative Growth Stocks
I also invest in speculative growth stocks. These are companies riding long-term trends that represent growth opportunities with the potential to outpace the markets.
Growth companies tend to be disruptive, creating more innovative products or services to displace the market share held by more mature companies that struggle to evolve.
Examples of long-term disruptive trends include:
- Cloud computing
- Software as a service (SAAS)
- Electric vehicles
- Remote working
- Distributed and renewable energy (solar, wind, etc.)
- Electronic payments
Early attempts made at speculative stock investing left me discouraged years ago.
My failures — picking lousy stocks, buying the wrong trends too early, or selling good stocks too early — caused me to fall back to dividend growth investing because it’s what I understood best.
But witnessing stocks like Amazon and Netflix soar while I was on the sidelines has brought my attention back to growth stocks.
I’m also more comfortable with speculative investing today because I have more money to risk. If I buy a long-term winner, I won’t be as tempted to sell because it is unlikely to become a significantly over-weighted stock in my portfolio.
But I’ve kept my speculative investing to less than 5% of my net worth and no more than 15 growth stocks.
And I’m better equipped — I subscribe to a stock selection service to help identify the kinds of stocks capable of doubling or tripling my money. Finding the right kind of companies on your own is riskier, difficult, and takes a ton of time.
It’s worked. I own eight stocks that have more than doubled in the past four years. One is up nearly 800%. Two are up 300%.
These excellent returns may not hold. Another market downturn or slowed growth may adversely affect the performance of these stocks.
I’ve also bought a few losers. But that’s part of the territory.
The goal with speculative growth stock investing is to identify the trends and stocks poised to rise and HOLD them for as long as they run.
As I learned with Apple, holding can be as hard as picking the right stocks.
Growth Stocks vs. Dividend Stocks
So what’s the difference between growth stocks vs. dividend stocks?
Well, it’s not whether the company pays a dividend or not.
Some growth stocks pay a dividend. Look no further than Apple and Microsoft. Both generate so much profit they can afford a dividend, save cash, and still invest for optimal growth.
But many fast-growing companies need all their capital to expand into market opportunities. So they retain earnings to invest back into the company.
Amazon, for example, has never paid a dividend. The company invests every penny into its employees and to expand into other markets.
Many dividend stocks, on the other hand, don’t always have endless opportunities to invest for growth.
Dividend-paying companies pay out a portion of their earnings as dividends and invest the rest back into the business. Balancing the use of retained earnings and dividend payments is a massive challenge for management.
Pay too high a dividend, and there isn’t enough to invest for growth. Invest the retained earnings poorly and experience the wrath of unhappy shareholders.
Pay no dividend, and there better be consistent quarterly growth.
It is never my intent to advocate for one investment strategy over another. I try to deliver the relevant risk/reward variables of different methods to empower investors to make the best decision for their unique situation.
Therefore, this next section about pros and cons is meant to inform rather than convince.
Pros of Growth Stocks
The most significant advantage of growth stock investing, and the reason I’m buying them is the potential to achieve alpha, the percentage return above a market index return.
Index fund investing will guarantee you won’t beat the market because the strategy aims to match the market returns.
Beating the market with dividend growth investing is possible. But it takes a strict adherence to the dividend growth strategy to achieve the objective, and you’re unlikely to blow away the market.
Many dividend investors, myself included, prioritize growing income over market outperformance.
Growth stock investing is about beating the market — and it is possible despite the stock-picking police who say individuals won’t beat the market because most mutual fund managers can’t do it.
Mutual fund managers are professionals, but they manage a lot of money and have high expenses. Being responsible for investing so much money means buying hundreds of stocks, sometimes thousands, to deploy their investors’ cash.
Mediocre stocks will dilute the big winners for mutual funds.
Individuals can own far fewer growth stocks, narrowing in on the top 1% of growth companies.
Another benefit of growth stocks is that there’s no taxation of dividends when there are no dividends — contrary to the primary criticism of dividend stocks. Focusing on non-dividend paying equities will only trigger a taxable event upon the sale of stock.
Hold the stock, pay no tax.
Index funds pay dividends. So indexing won’t save you from the dividend tax.
Pure growth stocks will.
Cons of Growth Stocks
Choosing long-term winning stocks and holding them is difficult. Spotting trends and acting upon them by purchasing the right stock at the right time will challenge any investor.
It takes experience to research markets and companies.
Not having the time or knowledge to do the research is the biggest drawback, an issue shared with dividend investing but not indexing.
Buying a speculative investment on a stock tip alone makes it even more speculative, lowering your chances of success.
I failed at choosing growth stocks early in my investing career, so I decided to give up. However, I did pick winners — but I failed to hold them long enough.
One way to reduce research time is to narrow the pool of potential investments. I’ve done this by subscribing to the Motley Fool Stock Advisor newsletter.
The Fool has a list of buy recommendations, which I use as a starting point to begin my research.
Another downside of growth stock investing is volatility. Growth stocks fluctuate more wildly than steadier, more established companies. They have a higher beta, meaning when the S&P 500 falls, the high-beta growth stocks fall further.
Similar story on the upside.
Owning winning stocks during the inevitable roller coaster of huge increases and epic price craters takes a stomach of steel. Most of all, it takes patience and conviction.
Your money will be tied up for years, decades even, to experience the 1000%+ gains, or multi-bagger stocks as Peter Lynch first called them. There’s still liquidity, but not if you want the wealth-changing returns.
Lastly, with high-flying growth stocks, you’ll eventually need to sell and pay capital gains. Selling a position with profits of tens of thousands of dollars will cause a large capital gain.
It’s a good problem to have, but avoid it by using tax-advantaged accounts when possible.
Sell in small chunks over multiple years to liquidate slowly and avoid large tax bills.
Pros of Dividend Stocks
Receiving regular payments from stocks is the primary perk of dividend investing. The income can be used to supplement your full-time income and can eventually replace it if you invest enough.
Investors can also reinvest dividends to compound their portfolio over time.
Dividend-paying companies must maintain the financial discipline to pay and increase their dividends annually. The dividend is one way shareholders hold management accountable.
With the remainder of profits, companies must effectively deploy retained earnings into profitable ventures, investing in future growth through new business areas or acquisitions.
Management’s ability to balance the dividend and effectively use of retained earnings is a key component of identifying worthy dividend investments.
Some companies, such as utilities, have limited growth opportunities and return a greater proportion of cash to investors. Real estate investment trusts (REITs) also provide higher dividend payments to supplement active income or fund retirement expenses.
Assembling a diversified portfolio of various sectors, yields, and dividend growth rates, validating against dividend safety measures, will increase an investor’s odds of generating a reliable and predictable income stream.
Just because a stock pays a dividend doesn’t mean it can’t grow. Disney, Coca-Cola, Altria, and Apple are all examples of stocks that achieved extraordinary capital growth while paying and increasing a dividend.
Cons of Dividend Stocks
Owning dividend stocks in a non-retirement account will create a taxable event for every dividend payment. The higher the yield, the higher the tax.
Though the tax rate is lower than that of earned income, it’s still a tax. Elected officials may change the tax rate someday, affecting returns.
This fact is the primary criticism of a dividend-focused investing strategy, especially for younger investors — and rightfully so.
Corporations have paid dividends for more than a hundred years, so this is nothing new. However, a broader array of more accessible funds and ETFs have given investors more options to avoid and reduce the dividend tax.
A strict index fund strategy will help, but it’s not the answer. Index funds pay dividends too.
The best way to avoid taxation is to own dividend stocks in a traditional, Roth, or SEP IRA (for business owners) where the dividend payments are not taxed. Max out and utilize those accounts first.
You can also reduce the tax burden by owning tax-efficient funds or dividend-paying growth stocks that pay a dividend yield below one percent but grow the dividend at a high rate every year.
Visa (V) is one such example. Its dividend yield is 0.61% today but has increased its dividend by 20% each of the last five years. The yield remains low because the stock price continues to rise.
You can also sell losing stocks to offset up to $3,000 of dividends with capital losses.
Another disadvantage of dividend stock investing is that though management is accountable for the dividend, they may miss growth opportunities if the dividend payment becomes overbearing.
Sometimes companies force themselves to issue debt to pay for growth yet continue dividend payments.
That’s a backdoor way to borrow to pay a dividend. If this habit continues for too long without significant proceeds from investments, continuing both the debt and dividend may become unsustainable.
When it catches up to a company, the dividend is cut first.
This brings us to a final downside of dividend investing — dividend cuts.
Income investors may become reliant upon dividends to cover living expenses. During a market or economic downturn, companies may be forced to cut dividends. Cuts can put at risk a portfolio if not adequately diversified.
Dividend cuts tend to happen in clusters, as occurred in 2008 and again in April of 2020.
In 2008, my portfolio was hit hard by two dividend cuts because I only held twelve stocks.
This year, my portfolio holdings consisted of more than 50 dividend stocks, three of which suspended their dividends (DIS, ROST, and LUV). The impact on my income was minimal because none of them had high yields or were a significant portion of my portfolio.
Many of my holdings are industrial, technology, financials, and consumer staples companies, which continued to operate without significant pandemic disruption.
Conclusion and Recommendations
For the record, buying individual stocks is riskier than owning diversified funds. Don’t speculate with money you can’t afford to lose.
Max out and invest in tax-advantaged accounts first. If you still have money left over, use a taxable brokerage account.
Beginners should start investing in stock market index funds and ETFs such as the VTI or SPY first. Learn how to invest using broad market index funds, then ease into owning individual stocks if comfortable, whether it’s dividend stocks for income or growth stocks for appreciation.
Once you’ve established a foundation, ideally in a tax-advantaged account, then you can begin taking greater risks with individual stocks in pursuit of passive income and alpha.
But make sure to diversify from the start — own at least ten individual stocks to spread your risk.
You’ve reached the end of this blog post.
From here, I’ll provide a bit more information about the services I mentioned above and make a few recommendations for those interested.
Instead of buying one stock or ETF at a time, you can create the ideal portfolio first, then slowly fund it over time.
As for stock selection, going it alone takes research and time. Beginner and intermediate investors are capable if they learn and put in the time.
I recommend a few books here; in particular, Peter Lynch influenced me early on. His examples are a bit outdated now, but many of the principals remain valid.
I spent way more time researching stocks in my youth but have turned to paid investment newsletters as supplemental research tools now that I have less time.
These help me narrow the pool of companies to consider, along with free resources such as the Dividend Champions, Contenders, and Challengers list.
For dividend stocks, I subscribe to the Sure Dividend Newsletter. This subscription service recommends ten dividend growth stocks every month and ranks hundreds of other stocks based on their research models.
I use their rankings as one tool in my belt before applying my analysis.
For growth stocks, I subscribe to The Motley Fool Stock Advisor newsletter and sometimes act upon their recommendations after due diligence. That’s not the only one I subscribe to.
Check out my list of best stock newsletters for buy-and-hold investors.
It started with listening to the Rule Breaker Podcast, where I started picking up pointers.
I never thought I’d pay for a stock picking service, but the Fool offered me a 1-month subscription trial to test it out (same deal as everyone).
I liked it so much that I became a paying subscriber and an affiliate partner to promote the service as part of my business (here’s how I make money blogging).
The recommendations I’ve received from Stock Advisor have made me tens of thousands of dollars so far, easily paying for itself (it costs $99 for the first year).
These results may not be consistent with your own.
Stock Advisor has far exceeded my expectations, and I am now a full-fledged subscriber and advocate. Please read my Stock Advisor review to learn more about the service. I’ll get a referral bonus if you sign up through one of my links for Sure Dividend, Stock Advisor, or any other services offered by the Fool.
Since the recommendations are proprietary, I do not overtly share the specific tickers of the stocks that have performed the best. Though I mentioned some in an earlier post, just because I own them doesn’t mean they are good to buy today — the newsletters highlight when it’s best to buy, sell, and hold recommendations.
I was 100% skeptical when I first signed up for stock newsletters, but I’m now fully behind these services. They make me a better investor.
What’s your take on growth stocks vs. dividend stocks? Do you have a preference, and why?
Disclosure: The author is long VTI, DIS, TSLA, AAPL, MSFT, V, ROST, LUV, KO, MO, AMZN
Featured photo via DepositPhotos is used under license.
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