Should I invest in stocks of companies that regularly distribute dividends? Or should I rather invest in companies that reinvest their profits?
If you are a new investor who has just started buying stocks and you’re unsure which option would deem more profitable in the long run or is a better use of the money you are planning to invest, don’t worry you are definitely not alone! These mind-boggling questions have challenged even the brightest, most experienced investors!
The first question to ask yourself is: don’t you want quick returns that you could spend and enjoy quickly? If your answer is yes, I can’t blame you because at the end of the day who doesn’t?! A bird in the hand is worth two in the bush! Clearly, if you are this type of investor you should opt for a dividend-paying stock. Yet, if you are more of a disciplined investor who can sacrifice short-term gains for longer term larger gains, then you should opt for a stock that does not pay dividends where the company’s CEO rather retains the profits and invests them in value-accretive opportunities.
Accordingly, in the long-run your stock will appreciate in value and you can sell it for a higher price. The profit you would capture would be the difference between the current price at which you are selling the stock minus the initial price at which you had originally bought it, and this spread between both prices is commonly known as the capital gain or capital appreciation, and you can even divide it by the initial price and voilà you now have calculated your capital gains yield.
What other considerations should I consider?
Clearly, there are other aspects that you should take into consideration when evaluating such a significant decision like the capital gains tax rate in the country you are investing in compared to the tax rate applied to dividends, which makes the tax policy an indispensable deciding factor in your decision, as it impacts the net gain you get from either capital appreciation or dividends.
In drawing things to a close, another point that an investor should put into perspective is his/her personal needs of liquid money or as it is more sophisticatedly referred to as cash on hand. This is also what is known by companies as the “clientele effect”. For example, if you are an older investor for instance, who constantly needs cash for everyday expenses and do not have another source of income it would definitely be wise to invest in a dividend-paying stock especially since you can get cash without having to sell the stock itself.
Additionally, if a person tends to squander his/her money buying stuff they actually don’t need and many of us can say that at some point in our lives we’ve been there, done that… then it would be beneficial in this scenario to buy dividend-paying stocks since it could act as a self-imposed barrier preventing us from overspending since we limit the money we can spend to the collected dividend rather than selling the stock and wasting the whole amount.
Worth mentioning, dividends can also shorten the payback period of a stock which means it takes less time to recollect the amount you originally invested and this could prove useful in certain circumstances, where you can take this money and invest it elsewhere as well as it overall reduces your risk and you can rest assured that you have at least collected back your initial investment which is a quite comforting feeling for most if not all investors.
A common trap that many investors fall into is buying the stock after a dividend is announced thinking that they can seemingly get the best of both worlds through guaranteeing that they are entitled to receive the upcoming dividends and then later on selling the stock.
It is essential to note that merely owning the stock on the day the dividends are paid doesn’t guarantee that you are entitled to receive the distributed dividends. Instead, you must have bought it on or before the record date for you to receive the next dividend payment.
We cannot say that dividends or capital gains are necessarily BETTER. On the contrary, you should evaluate a diversity of aspects to evaluate which option fits YOU best as an investor. Thus, even though this article does not discuss all the possible aspects…..making an informed decision begins with you knowing yourself as an investor, your needs, expectations and risk tolerance.