With the market moving to a risk-off environment, the question of whether to buy dividend stocks or growth stocks is top of mind for investors.
The answer lies in understanding your own personal investor profile. While some may argue dividend-paying stocks are a safer place to put your money as multiples condense, many growth stocks have fallen to very attractive prices. Ultimately, it is a question of overall risk tolerance and investment timeframe.
The importance of understanding business life cycles
Before answering this question for yourself, it’s important to understand that nearly all publicly traded companies fall into one of three business cycles: raising capital, self-funding, and returning capital.
Companies that are in the raising capital stage are highly dependent on new injections of cash for operations, either from secondary offerings (offering additional shares) or taking on new debt. These companies are very early in their life cycles and are high-risk, especially in a rising interest rate environment.
Once a company becomes consistently profitable, it is in the self-funding stage. This is a sign of a healthy business, and these companies can often continue to grow self-sufficiently for many years. The risk is lower than that of a company in the previous stage.
Finally, mature businesses will often elect to return capital to investors in the form of dividends or stock buy backs. This typically occurs when the business is generating very healthy profits, but has reached the pinnacle of its growth.
The argument for dividend stocks
As explained above, companies that offer dividends are mature, steady businesses. The overall risk profile for these investments is much lower because it’s less likely that businesses in this stage will go bankrupt. As you would expect, the lower risk means lower upside.
Building your portfolio around dividend paying stocks is a great strategy for investors nearing retirement because your portfolio becomes a source of passive income. The inherently lower risk of these stocks also makes sense to older investors as they look to preserve their capital as opposed to significantly grow it.
Some examples of strong dividend-paying businesses include:
Coca Cola (NYSE: KO) — pays a dividend of 2.96%
AbbVie (NYSE: ABBV) — pays a dividend of 4.08%
In addition to the dividends, both of these stocks are slightly up in 2022, in a year where the S&P 500 is down over 20%.
An important term that dividend investors need to know is “dividend aristocrat.” This describes a company that has consistently raised its dividend payout for 25 years or more. This is an indication of a very strong business, and both the stocks mentioned above are in this esteemed company.
After hearing all this, you might be ready to move your entire portfolio into dividend stocks. But there are serious risks; namely, investing in a stock simply because it has a very high dividend yield. A high yield (over 5%) should be viewed as a red flag, as struggling companies will often offer jaw-dropping payouts to attract investors.
But perhaps the most important risk is investing solely in dividend stocks when you have a very long investment time horizon. Once again, this is a personal decision based on your own risk appetite — but as a young investor, your goal should be to grow your portfolio, not protect it.
The argument for growth stocks
It’s no secret the market has been brutal this year for growth investors. This is the price of admission for aiming for outsized returns over the long run.
For investors who are still decades away from retirement, growth stocks offer significantly higher upside than dividend stocks. This is because instead of returning cash flows to investors, these companies are investing aggressively back into their businesses to grow their products and services or enter new markets.
Some examples include:
The Trade Desk (NASDAQ: TTD), which has seen its stock rise over 1,400% over the last six years
Tesla (NASDAQ: TSLA), which as appreciated nearly 1,500% since 2016
The Vanguard Dividend Appreciation ETF (NYSEMKT: VIG), by comparison, has risen 200% over the same period.
The risks of growth stocks are apparent. The Trade Desk is down 48% year-to-date, and Tesla has fallen 45%.
Growth investing requires emotional and psychological fortitude, but as you can see by the six-year returns that, over the long run, high-quality growth companies outperform.
Because these stocks are highly volatile and run a greater risk of going bankrupt, diversification is incredibly important.
Know your risk tolerance and invest accordingly
The best decision is the one that suits your investor profile. The two main factors in determining your investor profile are your time horizon and tolerance for risk.
Unless your risk appetite is extremely high, you’re probably best off allocating a percentage of your portfolio to both growth and dividend payers. Remember, your ideal portfolio is the one that lets you sleep like a baby at night.
Mark Blank has positions in Tesla and The Trade Desk. The Motley Fool has positions in and recommends Tesla and The Trade Desk. The Motley Fool recommends the following options: long January 2024 $47.50 calls on Coca-Cola. The Motley Fool has a disclosure policy.