If you spend time on X or other social media, you’ll see people talking about dividend investing. You’ll also see people saying that no one should be investing in dividend stocks, instead just investing in growth stocks. Why the divide? Who is right?

Today we’ll talk about dividend investing and when it makes sense for you. We’ll also talk about the advantages of growth investing. In the end, a mixture based on your personal situation and needs is the best path.

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What is a dividend and why do some companies pay them and not others?

When a company makes a profit, they can do different things with the money. They can:

1. Reinvest the money into the company by paying raises to retain key employees, increasing research and development, adding production capacity, or in other ways.
2. Buyback shares of stock, reducing the number of shares outstanding and thereby increasing the value of everyone’s shares.
3. Pay out the money directly to shareholders as a dividend.

Reinvesting, if done well, will increase the value of shareholder’s shares in the future as the company is able to make even higher profits from their investments. Stock buybacks, theoretically, will raise the value of the stock by reducing the number of shares outstanding. (In actuality, companies that are issuing shares to executives are just closing the loop when they’re buying shares back since they’re creating more shares with the distributions and then reducing them again with the buyback.)

The third way is to pay the cash out the shareholders directly as a dividend. Here, the company decides how much of the profit they will pay out, divides the total by the number of shares outstanding to determine how much will be paid per share, and then sends out a check to shareholders who owned the stock on a particular date (called the ex-divided date). This is usually deposited in your brokerage account these days, but it can be an actual check sent to you if you hold the share certificates yourself. If you have 1000 shares, you’ll get ten times as much cash as someone who has 100 shares. The percentage paid out per year is called the yield.

Note that all three uses of the money will reward shareholders. The first two will (normally) cause share price to increase, allowing the shareholder to sell shares and collect the money if they wish. Dividends give investors cash directly, so they can use the cash as they wish without selling shares. This is particularly useful if there is a high cost for them to sell shares (such as a high brokerage fee).

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So, with dividends you get cash and get to keep your shares, too?

At first blush, dividends may seem better than the other two possibilities. If a stock goes up and you sell shares to take money out, you’re losing shares. With a dividend you get to keep all of your shares plus get some cash. That’s better, right?

No, they’re actually equivalent. When a company declares a dividend, you’ll notice that the price per share drops on the ex-dividend date. This is because people buying the stock after that date will not get the dividend. Effectively whatever cash the company has to pay the dividend is gone once the ex-dividend date passes, so new shareholders aren’t going to pay someone for it when they buy the shares. If you have a limit order in to buy or sell a stock when the ex-dividend date happens, you’ll even notice that your brokerage will actually adjust your limit price by the dividend. For example, if they’re paying out a 5% dividend and you have a limit of $95 set for a purchase of a stock trading at $100, the brokerage will drop your limit price down to $90 since the stock is now worth 5%, or $5, less per share.

Think of it this way: What if someone were buying a small business and the business had $100,000 of cash sitting in their company account. Let’s say the business itself (the equipment, processes, brand, etc…) is worth $50,000. If you got the cash with the business, a fair price for the business would be at least $150,000 and a buyer would likely be willing to pay about that amount. If the owner took all of the cash with him and you were only getting the business, however, most buyers would only be willing to pay about $50,000. Once the company pays out the dividend, they become less valuable.

If a company regularly pays a dividend, they will build up cash from the business during each quarter, so the share price will rise a little, and then they will declare the dividend for the shareholders on the ex-dividend date, then the price of the stock will drop back down. There will be swings in share price due to other things such as world news, the sentiment of the markets, and events at the company, so the movements in price due to the cash building up may be obscured, but they will be there. The drop in price after the ex-dividend date will be most pronounced since it happens on one day where the cash building up will happen throughout the quarter.

So, there is really no difference whether a stock pays a dividend or you sell some shares after a company has made money and risen in price. In either case, your stake in the company will be worth a little less after it is certain that you will be receiving cash. It then comes down to a matter of whether it is convenient for you to sell shares or if it is better to just receive a dividend. Note that if you don’t want the dividend and would rather keep the money in the company, you will need to reinvest the money you get from the dividend in the company after you receive it. This can have a cost, depending on what the stock price was at when you received the dividend and what it is worth when you reinvest. Dividend reinvestment plans can be useful to minimize these costs.

You will also need to pay taxes on the dividend if the shares are in a taxable account even if you reinvest. At times, capital gains taxes may be lower than taxes on dividends, so that is another consideration. Obviously, if you aren’t using the money and just reinvesting the dividends, having your big dividend payers in your tax-sheltered account like an IRA is generally a good idea.

If you’d like to learn more about how to decide how much you should put in different types of assets, Sample Mutual Fund Portfolios gives lots of information and examples of how to make allocations for all sorts of different goals, including retirement.)

Dividend paying companies and those that do not tend to be different kinds of companies

Companies that pay larger dividends tend to be those that generate a lot of cash from operations and have little need to grow and expand. A common example is electrical utilities that have a relatively fixed customer base and just collect money from them based on the amount of power they use. The amount they collect each year is relatively fixed with slight increases due to population growth and heavily regulated rate increases. They just need to maintain their equipment and pay their employees. There isn’t much research and development going on. They therefore are able to pay a relatively fixed dividend to shareholders. They have nothing better to do with the money.

A young start-up company, on the other hand, needs all of the cash they can get for their business. They need cash to develop new technologies and processes, hire on new employees as they grow, acquire businesses, and produce more products as they gain more customers. Their business is also fairly uncertain so they need a good cash reserve to avoid running out of money. Chances are good they’ll need to borrow money and issue new shares to raise capital as they go, so it would make little sense to pay money out to shareholders while they are trying to raise more money. These types of companies therefore rarely pay a dividend, especially one of any large percent yield.

So, companies that pay big dividends are going to be the larger companies. These will tend to be more stable and predictable, both in share price and earnings. Companies that don’t will tend to be companies that are growing more rapidly and need all of their cash to fund that growth. (It is also possible that they are poorly managed, so it is important to look at their earnings and see if they are actually putting that money they are keeping to good use.)

This means that if you hold a basket of companies that pay bigger dividends rather than those that pay a small one or no dividend, you’ll tend to see smaller random fluctuations in your portfolio value because earnings will be more stable and predictable, but your total returns over long periods of time will tend to be less. Your big dividend payers will be sensitive to changes in interest rates since people will be buying them for the dividend, so you can still see large declines if interest rates rise a lot. But you won’t see changes as big when people get excited or scared about the economy. If you hold through the interest rate hike, you’ll then see your share prices go up again when rates are lowered back down. (A good strategy is therefore to buy dividend stocks when rates are high and sell them when they drop back down.)

Held for 15 or 20 years, you might get a 10-12% average return from the growing companies with no dividend and only an 6-8% average return from those that pay a big dividend. Of course, you can mix the two and have higher returns but with greater stability. For example, an 80%/20% growth/dividend stock portfolio would be more stable than a 100% growth one yet provide nearly the same returns.

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Who should be a dividend investor?

So, who should be buying high dividend paying stocks? Generally it is people who need cash on a regular basis to pay their bills. This could be a retiree who needs money for living expenses. It could also be a college student who is using a portfolio to pay for tuition and bills through college. It could even be a small business owner who wants income while their business is getting off of the ground.

The beauty of dividend stocks is that they tend to be large, stable companies with stable earnings. People still need electricity during a recession, so the earnings of the local utility will likely stay up and they’ll keep paying out their dividend even when the earnings of other companies go negative because business slows down in a recession. Even if the share price of the dividend paying company goes down, as long as they keep paying out the same dividend, you can get the cash you need for your bills and then just wait for the price of the stock to recover. If you need to sell shares to pay your bills in a growth stock portfolio, you might need to sell at a lower price because you need the money then and can’t wait for a better price.

That said, you won’t be risk free with dividend stocks. If the economy is bad enough, companies may need to cut their dividend. A company that makes a big mistake and sees their earnings decline rapidly may need to cut their dividend as well. Some even eliminate them.

You will also do better if you need cash for a long period of time if you have a growth portfolio where you sell some stock from time-to-time to raise cash because your returns will be larger. You just need to have a big enough portfolio that you are able to sell enough stock to cover your needs without selling off too much of the portfolio during downtimes. For example, if your cash needs are about 1% of your portfolio value, even if the portfolio drops by 30% during a bad bear market, you won’t be selling much of it to cover your expenses before the portfolio has time to recover. If you need 10% of the portfolio value each year, however, a big downturn can seriously damage your ability to make the portfolio survive and not be spent out before you’re ready.

Having both some dividend stocks and some growth stocks is also a good idea is general. The dividend stocks will provide some stability, which will help you sleep at night. The growth stocks will provided a larger return, giving you a bigger portfolio in the future. What percentage of each you have depends on how long you have until you really need the money and your personal tolerance for swings in portfolio value. Most people would start out a retirement portfolio with growth stocks when they are young and have decades until they need the money and then gradually transition to more and more dividend stocks as they near retirement age and enter retirement. Once they are very old and have little time left, they’ll probably be nearly 100% in dividend stocks since they will have no time to recover from a big decline in share price. Of course, by that point they may be leaving much of the portfolio to their kids if there is still a substantial amount of money in it, so it won’t really matter much whether it is more growth or more dividend stocks.

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmalllIvy

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing..