Flabia MaharjanInvesting requires an individual to be well informed about the types of investment. It may comprise of dividend investing or growth investing, whose advantages and disadvantages vary upon an investor’s investment goals, investment horizon, and risk preference. A prominent difference between dividend stocks and growth stocks is how excess returns are used by the company behind the stocks. With dividend stocks, one can expect periodic dividend payments, while with growth stocks, one aims to benefit from the increased stock prices. Let us now understand dividend stocks and growth stocks in more depth by analyzing the pros and cons that lie while investing in the two.
Dividend Stocks
Investing in dividend stocks means signing up for steady dividends on one’s investment. It is usually a corporate strategy to pay dividends through the profits earned by the company. Therefore, the excess return is declared and shared amongst the investors, and the excess profit is distributed as dividends. Dividend-paying companies focus on controlling expenditures since the profits are distributed to investors and not reinvested in the company. However, one must be careful since it is not a compulsion that the dividends be paid from the profits earned by the company. It may create a false impression on investors that a company is doing quite well since it is paying dividends, but the company might have declared a dividend from its past accumulated profit while its current net profit is negative. So, companies paying dividends are not always a safe bet since it could be a strategy to maintain investor confidence while the stocks are stagnant. We can always refer to the dividend payout ratio to assess what portion of the company’s earnings has been paid out to its shareholders and what portion has been retained to reinvest for growth, pay out debt, or maintain cash reserves.
An advantage of dividend investing is that an investor receives regular income in the form of dividends and could also benefit from the stock market value growth. Moreover, dividend stocks are believed to outperform growth stocks and reflect a sound financial condition of the company due to its ability to pay dividends. Nevertheless, as mentioned before, it is crucial to know the source of the dividend payments in order to classify them as good or bad. One of the biggest misconceptions regarding dividend stocks is that high dividend-yielding stocks are the best. However, it might not always be a good sign when a company is returning so much of its profits to its shareholders rather than investing in its growth. Dividend stocks are generally recommended to investors with a short investment horizon and high liquidity needs.
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Growth Stocks
From an investment point of view, an investor investing in growth stocks expects to derive maximum capital gain from increased stock prices. An investor projects a company’s growth in the near future resulting in a subsequent asset value growth. Such a company emphasizes reinvesting the excess return in the company itself. The management recognizes any opportunity to help an organization grow and uses the retained earnings for the same purpose. This is expected to result in stock price growth which is why stocks of such a company are known as growth stocks. Growth-focused companies are not afraid to spend money on growth. This is common in new companies who will have to spend a sufficient amount in order to make themselves known in the market, which is why it is normal for such companies to have a dividend payout ratio that equals zero. Hence, with growth investing, the money remains invested in the company and is not paid out to its shareholders in dividends.
An investor would have to wait for a longer period in order to benefit from investing in growth stocks which is why this type of stock is recommended to investors with a long investment horizon and low liquidity need. Unlike dividend stocks, an investor does not generate additional returns while he holds on to growth stocks. The only way to enjoy capital gains is to sell the stock once it has risen in value which is why it should be opted for by investors who do not require much liquidity. Only after a reasonable time will the growth stocks transform into high-value stocks which the investors can sell to receive the maximum capital gain.
The growth aspect is what differentiates growth stocks from dividend stocks. It is considered a good thing if a company is investing in its growth since it will help in increasing organizational efficiency, which in turn results in increased productivity. Reinvestment (over dividend payments) paves a path for asset value growth in the future.
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Investment Decision: Dividend Stocks Vs. Growth Stocks
So, do we invest in dividend stocks or growth stocks? Our decision depends upon our risk preferences, investment horizon, and most importantly, our investment goals.
Risk
Growth stocks are riskier in comparison to dividend stocks. With growth stocks, we expect the stock prices to escalate with time. However, growth investing might backfire on us, and we may end up losing money for holding the stock in the hope of capital gains. Although we seek volatility while investing in growth stocks, the prices may soar or plunge, elucidating higher risk.
Dividend stocks are considered less risky because dividend-paying companies are generally those that have achieved a level of maturity and are well-performing; in a sense, the payments are stable and reliable. But we must remember that dividend payments from dividend investing are much less than capital gains from growth investing. This is because distributing profits rather than reinvesting reduces the chances of a potential increase in stock prices. Hence, one can always earn more if an investor’s risk-bearing capacity is more and chooses growth stocks over dividend stocks.
Investment Horizon and Liquidity
Investment horizon describes the length of time an investor is willing to hold a security to gain value on their investment. Growth stocks require an investor to hold stocks for a longer time frame, i.e., months to even years. Over time, you expect the stock value to rise so that you can finally sell it and enjoy your capital gain earnings. A longer investment horizon is directly related to liquidity. Since an investor needs to wait for long-term capital gains, their money gets tied during the time of investment.
Dividend investing is a shorter-term model of investing. Investors benefit from regular dividend payments, and since they do not have to wait for long-term capital gains, they can quickly sell their stocks when they need liquidity. On top of that, regular dividend payments allow them to invest in more stocks. Although the payments are small, they can still contribute to growing one’s portfolio.
Conclusion
If we want steady cash flow over a short period, we should opt for dividend investing. Likewise, if we wish to achieve a return in the form of high asset value and have a longer investment horizon, it is better to invest in growth stocks. If we choose dividend stocks, we are building a portfolio around dividend-paying assets that have a history of returns in the form of dividends in periodic intervals. For this, we can either invest in individual stocks or mutual funds that invest in dividend stocks. The returns are more petite than growth stocks because the returns are in the form of periodically paid dividends, while the value of growth stocks can rise immensely due to reinvestment. When we choose growth stocks, we build a portfolio around stocks that we expect to grow in value over time. However, these stocks do not generate any return while we hold them, and this is why growth investing is a less liquid strategy than dividend investing. Returns are visible once we decide to sell the stocks we own.
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