Do you know who missed out on great growth stocks like Tesla, Apple, Netflix, Google, Facebook, and more over the last 10+ years? Dividend stock investors. For younger investors (<40), I believe it’s better to invest mostly in growth stocks over dividend stocks. With growth stocks, you increase your chances of accumulating more capital quickly.
You’d rather invest in a company that is providing more capital appreciation while you are working. After all, earning dividend income is less important when you have job income. Instead, building as big of a financial nut as possible with growth stocks is more important.
However, once you are retired or close to retiring, you can shift toward dividend stocks for income. You shouldn’t have as high of a tax bill in retirement due to a lack of W2 income. Further, dividend stocks are also relatively less volatile given their stronger balance sheets.
Dividend stock investing is a great source of passive income. In fact, I rank dividend stocks as a top source of passive income. The problem is, with dividend yields relatively low at 1-3% you need a lot of capital to generate any sort of meaningful income. Further, as a minority investor, there’s no way to improve the dividend payout ratio.
Even if you have a $1,000,000 dividend stock portfolio yielding 2% that’s only $20,000 a year in dividend income. Remember, the safest withdrawal rate in retirement does not touch principal. Further, you must ask yourself whether such yields are worth the investment risk.
Growth Stocks Over Dividend Stocks
If you’re relatively young, say under 40 years old, investing the majority of your equity exposure in dividend-yielding stocks is a suboptimal investment strategy. It’s much better to invest in growth stocks over dividend stocks.
If you decided to invest in dividend stocks while you are young, you’ll be hoping for filet mignon for decades while you eat Hamburger Helper in the meantime. When you reach your desired age for retirement, you might just be asking yourself, “Where the hell is the feast?“
Out of the few multi-bagger return stocks I’ve had over the past 20 years, none of them have been dividend stocks. Over time, dividend stocks will provide healthy returns. But if you are like me, you’d rather build your fortune sooner rather than later.
If I’m going to bother taking risk in the stock markets as a minority investor facing countless unknown endogenous and exogenous variables, I’m not playing for crumbs. When things turn south, everything turns south. Therefore, I want to be rewarded with higher potential capital appreciation.
Just know that when there is a downturn or a surge in interest rates, growth stocks tend to get pummeled much more than dividend stocks. Therefore, as a growth investor, you need to be able to withstand higher rates of volatility.
Fundamentals Of Dividend-Paying Companies
The main reason companies pay dividends is because management cannot find better growth opportunities within its own company to invest its retained earnings.
The other main reason management can’t find better acquisition opportunities with its cash. Hence, management returns excess earnings to shareholders in the form of dividends or share buybacks.
If a company pays a dividend equivalent to a 2% yield, management is essentially telling investors they can’t find better investments within the company that will return greater than 2%.
Pretend you are Elon Musk, CEO of Tesla Motors (TSLA), a growth company that pays no dividends. Do you think Elon is going to start paying a dividend with its profits instead of plowing money back into research & development for new models with longer battery lives? Of course not!
It would be absolutely pathetic if Elon Musk could not beat a 2% return on its capital. Tesla Motors motors went public in mid-2010 and has been one of the best growth stocks of all-time.
Thank goodness Tesla did not pay dividends, otherwise, the company may have gone bankrupt. Raising debt and reinvesting cash flow back into the company is what made Tesla a successful growth story.
Dividend Stock Example
Now let’s take a look at a telecom company like AT&T (T) which has the largest wireless network in America. Mobile phone penetration is over 88% in America according to Pew Research. AT&T also has the largest subscriber base in the industry.
The opportunity for accelerating growth is low due to the already high penetration rate. However, the cash flow generation is high since AT&T is like a utility that mints subscriber money in an oligopoly fashion. As a result of strong cash flow and no better investment alternatives, AT&T pays a fat dividend of ~$2/share, equivalent to a 7% dividend yield at today’s stock price.
Just look at the comparison between Tesla Motor’s share price in blue and AT&T’s share price in green and there is no comparison. You can’t even tell AT&T is in the chart. Over the past five years, AT&T is down 22.37%. Meanwhile, Tesla is up 2,340%. Which would you choose?
I’m a shareholder in both stocks and I regret buying AT&T for its dividends.
Collecting dividends is nice when you have a big portfolio and are near retirement. However, trying to grow wealth quicker through dividend stocks is a suboptimal decision.
A Misconception About Dividends
One of the main misconceptions about owning dividend stocks is that the dividend is free money. A dividend is not free money. Paying a dividend lowers the amount of cash on a company’s balance sheet, which in turn, lowers the equity value of a company.
The only reason why a dividend stock tends to rebound after paying its quarterly or annual dividend is due to expectations. If a company has a history of paying a dividend, then the stock tends not to decline by the amount of dividend paid. Expectations are high that a company like Coca Cola will continue to generate enough cash flow to pay another dividend like it has for decades.
If the amount of growth cannot overcome the amount of value lost from a dividend over time, a company will likely decline in value. If you happen to invest in a company that is not growing and is cutting its dividend payout, then you’ve found yourself a real dud.
Growth Stocks Have Life Cycles Too
One of the greatest growth stocks in history is Microsoft (MSFT). However, even growth stocks like Microsoft can’t always go up forever. Between 2000 – 2016, Microsoft’s stock went nowhere. Thankfully for shareholders, a new CEO revitalized the company and took advantage of the cloud.
If you were a young lad who decided to buy dividend stocks in the 1980s instead of Microsoft, you underperformed.
However, by 2003, Microsoft recognized that its Windows platform was saturated given it had a monopoly. Meanwhile, PC growth was stalling out too. Therefore, they started paying a dividend on January 17, 2003 because the company couldn’t find a better use of its cash.
As a dividend stock, Microsoft was not bad with a 2% – 3% dividend yield for about a decade. The problem when you get big is that its harder to grow as fast anymore. Just look at dividend stock, IBM, which has essentially gone nowhere since 1999.
Be aware of company life cycles. Not every company can evolve to take advantage of new opportunities, like Microsoft did.
How many companies did we know 10 years ago which are no longer around today due to competition, failure to innovate, and massive disruptions in its business? Tower Records, WorldCom, Circuit City, American Home Mortgage, Enron, Lehman Brothers, ATA Airlines, The Sharper Image, Washington Mutual, Ziff Davis, Hostess Brands and Hollywood Video are all gone!
This is why you cannot blatantly buy and hold a stock forever. You’ve got to stay on top of your investments at least once a year.
Dividend Investors Should Pay Closer Attention To Interest Rates
In a rising interest rate environment, dividend-yielding stocks, REITs, and bonds tend to underperform the broader market.
In a declining interest rate environment, as long as dividend-paying companies are continuing to generate good cash flow and maintain or increase their dividend payout ratio, they will be seen more favorably. Dividend-yielding companies look relatively more attractive as interest rates decline.
Currently, we are in a low interest rate environment. Low interest rates will likely be here to stay for years as the Fed promised to be overly accommodative until it sees inflation above 2% for a prolonged period of time. Inflation is not the issue here. Unemployment is.
As a result, blue-chip dividend stocks should do relatively well in a lower interest rate environment. However, look how much better growth stocks have done.
When interest rates are low, companies can borrow more debt more cheaply. If a growth company can borrow debt at 2% and invest the money to grow its business by 10%, a growth company will outperform a dividend company.
In a low interest rate environment, investors may wonder about management’s acumen of continuing to pay a high dividend yield when they don’t have to. Once again, growth stocks win.
“Dividend Growth Stocks” Is A Misnomer
Some people like to think they are investing in “dividend growth stocks.” Sadly, this is unlikely to be true. The words “dividend growth stock” are an oxymoron because the larger a company’s dividend grows the more it means management cannot find better use of its cash.
Again, management is trying to optimize the best use of capital. Since capital is limited, over the long term, a company can’t pay more in dividends if it finds better growth opportunities elsewhere.
Everything is relative in finance. A “dividend growth” investor may see 8% profit growth in one year as very enticing. However, a growth stock investor may be looking for at least 20% profit or revenue growth a year.
To help you better understand the dilemma between paying a dividend or reinvesting your company’s cash flow, pretend you are the CEO of a company. Your goal is to maximize the return of every dollar spent.
How Much To Invest In Growth Stocks By Age
Let’s say you agree that it’s better to invest in growth stocks over dividend stocks when you are younger. Let me share a guide for how much to invest in growth stocks by age.
These percentage figures for investing in growth stocks are for your stock-specific investments, which is a portion of your overall active and passive stock investments.
In other words, let’s say you have a $1 million investment portfolio. You decide to invest $600,000 in equity index ETFs like SPY and $200,000 in bond index ETFs like IEF. The remaining $200,000, or 20%, will be invested in individual growth stocks or dividend stocks. This is the portion of your investments we’re talking about.
Growth vs. Dividend Stock Weightings
Age 0 – 25: 100% growth stocks, 0% dividend stocks
Age 26 – 30: 100% growth stocks, 0% dividend stocks
Age 31 – 35: 90% growth stocks, 10% dividend stocks
Age 36 – 40: 80% growth stocks, 20% dividend stocks
Age 41 – 45: 70% growth stocks, 30% dividend stocks
Age 46 – 50: 60% growth stocks, 40% dividend stocks
Age 51 – 55: 50% growth stocks, 50% dividend stocks
Age 55+: 40% growth stocks, 60% dividend stocks
In my opinion, it’s always good to invest some percentage of your stock investments in growth stocks. However, as you get older and wealthier, you likely want to take less risk, experience less volatility, and earn more passive income.
Further, since dividend stocks pay dividends, you will also have to pay taxes on the income. If you so happen to already be earning a high income thanks to your day job, earning more dividend income is suboptimal, despite dividends getting taxed at a lower rate.
Your Main Investments Are Already Generating Income
Remember, your main index funds and ETFs should generate the bulk of your stock and bond passive income. Therefore, investing in more dividend stocks with your stock-specific investments may not move the needle. Instead, you might as well invest in growth stocks that will hopefully provide you stronger capital returns.
However, in a bear market, low beta, dividend stocks will likely outperform growth stocks as investors seek income and shelter. Once you’ve grown a sizable financial nut, your goal should shift more towards capital preservation.
My recommendations for investing between growth stocks and dividend stocks by age is just a guide. If you are more risk-loving, then you can certainly invest a greater percentage of your stocks in growth stocks and vice versa.
Just remember, you’ve already established a proper net worth allocation by age. My base case scenario in the second half of our lives is to have roughly a 30%, 30%, 30%, 10% split between stocks, bonds, real estate, and risk free investments. If you follow such a net worth split, then you already have a healthy amount of assets that are paying you income.
You’re only investing a minority of your investable assets in active investments. Therefore, you might as well try to see if you can outperform the most with growth stocks in this bucket.
Growth Stocks Versus Dividend Stocks Recap
Let me summarize why I think it’s better to invest in growth stocks over dividend stocks for younger investors.
1) It’s harder to build a sizable financial nut with dividend stocks quickly. Management is returning cash to shareholders instead of finding better opportunities within the firm to invest. Therefore, by definition, a dividend-paying company’s growth is anchored by its dividend yield.
2) Dividend stocks tend to underperform in a rising interest rate environment. Think about what happens to property prices if rates go too high. Demand falls and property prices fall at the margin. However, in a low interest rate environment, growth stocks tend to outperform because cheap money can be borrowed to reinvest in faster growth opportunities.
3) If you properly diversify your net worth you will already have a good portion of your net worth producing a steady stream of income through real estate, bonds, CDs, and other income producing assets. Adding dividend stocks is therefore adding more to fixed income type of assets.
4) Match your investment style with your stage in life. It is backwards to aggressively invest in dividend stocks when you are young when you’ve got little capital. When you are young with a little amount of capital, your primary goal is to build as much capital as possible. When you are older with a lot more capital, investing in dividend stocks makes more sense. You want to generate income so you don’t have to work. Further, you become more risk-averse because you have less time to make up for your losses.
5) If you think we are heading into a bear market, you will likely lose less investing in dividend stocks over growth stocks. Dividend-paying companies tend to have stronger balance sheets, stronger cash flow, and more defensible business models than growth companies. However, if you think a really nasty downturn is on the horizon, rebalancing out of equities may be an even better strategy.
6) To thoroughly understand the debate between investing in growth stocks or dividend stocks, you must think like the CEO or CFO of a public company. To help make your company a success, you must find the optimal use of each dollar. Using your company’s cash to pay a dividend means the alternative of reinvesting the cash into your company or acquiring new business aren’t as attractive.
You are free to invest in whatever type of stock you like. We all have different financial goals and financial situations. However, I hope you at least find the logic in my arguments.
A Powerful Investing Strategy To Consider
The final investing strategy to consider is buying growth stocks and investing in real estate, instead of dividend stocks. This powerful combination provides the best of both worlds: high growth and income.
I’ve invested in growth stocks and dividend stocks since 1997. Growth stocks have, by far, provided the most amount of returns since college. What I’ve also consistently done with some of my growth stock winnings is reinvest some of the proceeds into real estate. I’ve also used my savings to expand into real estate as well.
Real estate tends to provide more income than dividend stocks. Real estate also offers asset class diversification to dampen volatility. During stock market downturns, real estate often outperforms, as we saw during the March 2020 meltdown. I don’t enjoy seeing the value of my stocks go *poof* overnight. But I do like the steadiness real estate provides.
Although managing real estate is more of a hassle than investing in dividend stocks, I like the diversification. Further, by investing in private real estate syndication deals, I no longer have to deal with tenants or maintenance issues.
Favorite Real Estate Marketplace Platforms
I’ve personally invested $810,000 in real estate crowdfunding across 18 projects to take advantage of lower valuations in the heartland of America. Real estate crowdfunding investments and rental properties have supplanted my dividend stock investments. Together, they account for roughly $190,000 in passive income.
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends.
Both platforms are free to sign up and explore. I plan to continue investing in growth stocks and real estate for the foreseeable future.
Readers, I’m curious to hear your thoughts on the growth stocks over dividend stocks debate. Which type of stock do you prefer and why? Do you think “dividend growth stocks” is a misnomer?