Investing in Growth Stocks using LEAPS®

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Growth Stocks With Value: Part 2

Introduction
In part one of this series we introduced the notion that in all markets whether bear or bull, there will always exist individual stocks that are fairly valued, overvalued or undervalued. In this same vein we argued that it’s a market of stocks, not a stock market. For those who missed it, here’s a link to part one. To put this into context, we are simply suggesting that the discerning investor can always find bargains if they are willing to look and do their homework. However, we should also add that bargains can come from many different types of equities.

Therefore, this and the following articles in this series will look at bargains that can be found within various equity classes. In this part two, we will look for bargains in high-growth stocks. Although this may be the riskiest equity asset class of all, it is also the most profitable, as long as sound and prudent investing principles are adhered to.

High Growth Stocks Defined
One of my favorite quips is about Tennessee Ernie Ford leading his church’s choir when he allegedly said: “everyone turn to page 26 and sing along with me, but if you don’t have page 26 then sing page 13 twice, because we all need to be on the same page.” Therefore, as it relates to this article, in order for us all to be on the same page, we need to share a common definition of growth stocks, before a fair and impartial analysis can be conducted.

Consequently, for purposes of this article, we define growth stocks as follows: In order to be considered a growth stock, the company must have a history of growing their earnings in excess of 15% per annum, while simultaneously possessing a forecast expected future growth rate of at least 15% or better. For companies that possess these levels of past and future growth, we will utilize a PEG (PE equals growth rate) formula to calculate fair value. The valuation theory being applied states that companies possessing these significantly above-average growth rates deserve a premium valuation over slower growing peers.

The premium valuation concept presented above represents one aspect of why growth stocks, under our definition, possess higher risk than blue chips. First of all, achieving these high levels of growth are not only rare, but also extremely difficult to accomplish. Consequently, it is a challenge for companies to maintain high rates of growth, and this challenge is amplified the bigger the company gets. Therefore, we offer this very important caveat. Regarding growth stocks, it is even more imperative to focus on future growth over historical growth, than it is for any other equity class.

There is a second factor related to the above caution and that is the importance of valuation. Typically, Mr. Market will ask the prospective investor to pay a higher valuation (PE ratio) to buy a growth stock than most other equity categories. Having to pay a higher valuation for above-average growth is usually not only necessary, but also rational to a point. In fact, due to the high rates of potential growth, coupled with the power of compounding, means that above-average rates of return can be achieved with growth stocks, even if you pay a little more to buy one than you should. In other words, the compounding power of rapid earnings growth can bail you out from an aggressive purchase over time.

On the other hand, one of the most common mistakes investors make with high-growth stocks is overpaying for them. This usually occurs because of the hype that often leads to hysteria which tweaks the greed response. Companies with extremely high rates of growth can for a time attract significant investor interest leading to incredible short-term momentum. Consequently, a rapidly rising stock price can excite investor greed to the point of irrational behavior. One place where this psychological response is often seen is with hot IPOs. Later in this article we will present a vivid example of how dangerous this can be.

High Growth Stocks In The S&P 500
This series of articles is oriented to dealing with the wide diversity of equity classes that make up the S&P 500. Therefore, we are only going to concern ourselves with high-growth stocks that are constituents of the S&P 500. Of course, this also means that there are many very high-growth stocks that will be excluded from this discussion. Consequently, what follows is by no means presented as a comprehensive list of high-growth stocks.

Moreover, and most importantly, the following tables comprised of high-growth stocks in the S&P 500 also had to meet the hurdle of reasonable valuation. As a result, there were several S&P 500 growth stocks that did not make the cut. In other words, the following tables look at S&P 500 high-growth stocks that appear to be at or near fair value based on expected future rates of growth. S&P 500 growth stocks that we believe are overvalued were not included.

We have listed 17 S&P 500 high-growth stocks that met our criteria and we have organized them based on capitalization and earnings growth rate. Interestingly, all of the S&P 500 high-growth stocks that made our list are large-cap companies. Our first table reports on seven companies with earnings growth rates exceeding 20% per annum (The reader should note that both the 15-year historical EPS growth rate and the estimated 5-year EPS growth rate are both in excess of 20% in table 1). Our second table covers 10 additional S&P 500 growth stocks with historical and estimated growth rates in excess of 15% per annum.

Both of the following tables provide a summary of important fundamental measurements. The first two columns list historical earnings growth, followed by forecast EPS growth rates. The next two columns are focused on valuation by showing the historical normal PE followed by the current market PE. Then we provide debt levels and sector, followed by annualized historical performance, and finally, an estimate of future potential compounded annual rates of return. (It is important to note that the reader should understand that any companies on the list with poor historical returns (highlighted in red) can be assumed attributed to beginning overvaluation).

Analyzing S&P 500 High-growth Stocks Through The Lens Of F.A.S.T. Graphs™
Next we’re going to evaluate several examples from our list of S&P 500 high-growth stocks in value, utilizing the F.A.S.T. Graphs™ fundamentals analyzer software tool. This exercise will serve the dual purpose of allowing us to analyze the fundamental value of each company and to illustrate and elaborate on several of the points previously presented in this article. Furthermore, although we believe that the following analysis provides a comprehensive evaluation of the fundamentals underpinning each of these examples, additional due diligence is recommended.

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Cognizant Technology Solutions (CTSH)
Cognizant Technology Solutions is a leading provider of custom information technology, consulting and business process outsourcing services. The following earnings and price correlated graph on this quality company depicts a quintessential example of a true growth stock. Not only has earnings growth averaged 38% per annum, the consistency of the growth has also been extraordinary. This rate of growth is very rare, as few companies are capable of growing this consistently fast.

Furthermore, notice how stock price (the black line on the graph) has closely tracked earnings (the orange line on the graph) up through calendar year 2007, but has since deviated (see red circle). This long-term picture of the earnings and price relationship clearly alerts us that something has changed since 2008. The first reaction of course would be that the great recession of 2008 made an impact. However, upon further review we discover that the recession did impact stock price for sure, but we also see that earnings growth continued to advance nicely, thereby suggesting that this company was clearly recession resistant.

On the other hand, a glance at the bottom of the graph (see yellow highlights) shows that the earnings growth rate, although continuing to be strongly above average, had slowed down. However, thanks to the dynamic nature of the F.A.S.T. Graphs™ research tool, we can run a graph since 2008 (the recession), and analyze this inflection in earnings growth and the impact it had on price and valuation. However, before we do, let’s take a look at performance since calendar year 1999 in order to illustrate just how powerful a return generator that a high-growth stock can be.

When we calculate the performance that Cognizant Technologies has produced for its shareholders since calendar year 1999, we see a stunning example of the incredible power of compounding, and the incredible economic benefit it can provide. A simple $1000 investment in Cognizant’s stock on December 31, 1998, and held till now would have turned a $1000 initial investment into over $54,000 today. Comparing this more than 33% per annum compounded rate of return from this S&P 500 constituent to the S&P 500 itself, clearly illustrates just how powerful the return that this growth stock has produced.

A quick glance back at the historical earnings and price correlated graphic above shows that the company was reasonably priced with a PE ratio of just under 40, or only slightly above its 38% per annum earnings growth rate on December 31, 1998. Remember, the formula used to value high growth stocks is the PEG (PE equals growth rate) formula. Consequently, even though the company appears undervalued during the later years based on its historical growth which averaged 38% per annum, the compounded rate of return it provided shareholders is highly correlated to its long-term earnings growth.

Next, and as promised, let’s use the dynamic feature of F.A.S.T. Graphs™ and look at Cognizant Technologies since the beginning of calendar year 2008 (the great recession). Here we discover that our research tool has recalculated the company’s earnings growth rate and simultaneously provides a more recent iteration of fair valuation. Since calendar year 2008, Cognizant’s earnings growth rate has fallen from averaging 38% per annum to averaging 22% per annum.

Nevertheless, although this is still significantly above-average earnings growth, it does imply a valuation adjustment. Consequently, by applying the PEG ratio valuation because earnings growth is over 15%, we see that the market has been rationally valuing the company at its adjusted growth rate since 2008. Therefore, although it is useful to see how powerful this growth stock has been since 1999, it is also both imperative and useful to evaluate it based on its more recent history. This explains why the price was not tracking its long-term earnings growth rate during the latter years on the long-term earnings and price correlated graphic above.

When we review the performance of Cognizant since calendar year 2008, and consider that it was moderately overvalued with a PE ratio above 25 relative to an earnings growth rate of 22%, we continue to see evidence of the strong returns that a high growth stock can provide. Furthermore, this also illustrates that you can moderately overpay for a high-growth stock, and still generate a significant long-term rate of return.

Astute investors who purchased Cognizant on December 31, 2007, would have more than doubled their money, averaging approximately a 15.7% per annum return. When you compare this to investing in the S&P 500 Index, the value of owning a high-growth stock bought at a reasonable valuation is vividly revealed. Remember, that even though Cognizant was moderately overvalued, the power of compounding earnings growth during and through the great recession, allowed the company to provide its shareholders very attractive and highly above-average returns.

Priceline.Com Inc. (PCLN)
The long-term graphic on Priceline.com provides a lot of lessons on investing in general, but most importantly, on investing in growth stocks specifically. Additionally, the importance of investing at sensible valuations is clearly articulated. Furthermore, we can use this example to reflect on lessons to be learned when investing in IPOs, as promised earlier in this article.

Priceline.com went public on April Fools’ Day 1999; however, investing in its initial public offering was no joking matter. From the graph below we can see that for the first month after its IPO, Priceline.com’s stock price almost doubled in value. However, for the next 20 months or so following its price peaking, the stock fell from a high of over $974 per share to a low of $6.38 per share. Furthermore, it should be pointed out that there were no earnings being generated by the company at this time to support its high price.

When you measure the company’s price performance from its IPO in 1999 to year-end 2003, we see just how devastating overvaluation can be. A $1000 investment in Priceline at its IPO would have generated a compounded 50% per annum loss on its shareholders behalf, thereby turning the original $1000 investment into a mere $35.98.

The moral of this story is to not invest in IPOs no matter how enticing (think Facebook) unless the company’s initial earnings support the stock price. Since the company is going to trade for a long time, the patient investor would more often than not find a more attractive and rational entry point than they typically find at the IPO. With our next look at Priceline we will show how profitable this kind of patience can be.

F5 Networks Inc. (FFIV)
Our final example looks at F5 Networks Inc., a leading provider of application delivery networking technology. There are several lessons regarding investing in growth stocks that we believe this fast-growing technology enabler can teach us. First of all, we see another example of the extraordinary benefit provided from investing into a company with a powerful earnings record. Additionally, this company also teaches us a thing or two about valuation, and finally provides lessons on intelligently dealing with volatility.

From the earnings and price correlated graphic below we see that F5 Networks has generated earnings growth averaging 29.8% since calendar year 2005. Furthermore, we can clearly see that the company’s stock price, although generally tracking earnings, has experienced extreme bouts of high volatility on more than one occasion.

But even more importantly, we see the importance of trusting fundamentals over stock price movement, because every time stock price deviated from fair value over or under, inevitably it returns to fair value. We believe this validates our thesis that price volatility will only hurt you when you overreact to it while simultaneously refusing to acknowledge intrinsic value based on fundamentals. We believe there are two performance measurements for every stock. The first is price volatility, which can’t be trusted, and the second is fundamental value, which in truth matters most. Unfortunately, most investors ignore fundamental value as they are fixated on fickle price.

Summary And Conclusions
Our primary objective with this series of articles is to illustrate the truth that there is a lot of value in this market. With this part 2, we focused on high-growth stocks that were constituents of the S&P 500 that are currently trading at fair value based on their earnings potential. Although many of the stocks on our master list of 17 are currently trading at above-market PE ratios, we think the valuations are justified based on the earnings power of these extraordinary growers. This teaches us a lesson that valuation is a relative concept. In other words, a company with an extraordinary potential for growth is worth more than a company with a lower potential for growth.

The companies that we have featured in this article appear to be attractive high-growth candidates for the aggressive investor seeking maximum capital appreciation. However, this statement is based on a combination of the company’s historical operating history, coupled with consensus estimates for future growth. Furthermore, because these numbers are significantly higher than average, the notion of greater risk should be kept firmly in mind. On the other hand, the old adages that no risk, no return, also come into play. The bottom line is that although we feel this is an excellent list of S&P 500 constituents with high growth potential, additional due diligence is highly recommended.

Disclosure: Long AAPL, V, GOOG, MA & NOV at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Using LEAPS Over Stock to Generate Huge Returns

A Stock Option Strategy for Bullish Investors

If you are bullish on a particular company’s stock, you can structure your investment with Long-Term Equity Anticipation Securities (LEAPS), meaning a rise of 50% could translate into a 300% gain. Of course, this strategy comes with risks, and the odds are very much stacked against you. Used foolishly, it can wipe out your entire portfolio in a matter of days. Used wisely, however, it can be a powerful tool that allows you to leverage your investment returns without borrowing money on margin.

Defining a LEAPS Strategy

LEAPS are long-term stock options with an expiration period longer than one year. Acquiring them allows you to use less capital than if you’d purchased stock, and delivers outsized returns if you bet right on the direction of the shares.

Let’s use shares of General Electric (GE) trading at $14.50 (their price in mid-2020) as an example. Say you have $20,500 to invest. You are convinced that GE will be substantially higher within a year or two and want to put your money into the stock. You could simply buy the stock outright, receiving roughly 1,414 shares of common stock.

You could leverage yourself 2-1 by borrowing on margin, bringing your total investment to $41,000 and 2,818 shares of stock with an offsetting debt of $20,500. However, if the stock crashes, you could get a margin call and be forced to sell at a loss if you can’t come up with funds from another source to deposit in your account. You will also have to pay interest, perhaps as much as 9% depending upon your broker, for the privilege of borrowing the money.

Perhaps you don’t like this level of exposure. Given your conviction, you might consider using LEAPS instead of the common stock. You look to the pricing tables published by the Chicago Board Options Exchange (CBOE) and see that you can purchase a call option expiring nearly 20 months and 3 weeks away, with a strike price of $17.50.

Put simply, that means you have the right to buy the stock at $17.50 per share any time between the purchase date and the expiration date. For this right, you must pay a fee, or premium, of $2.06 per share. The call options are sold in contracts of 100 shares each.

You decide to take your $20,500 and purchase 100 contracts. Remember that each contract covers 100 shares, so you now have exposure to 10,000 shares of GE stock using your LEAPS. For this, you have to pay $2.06 x 10,000 shares = $20,600. You rounded up to the nearest available figure to your investment goal. However, the stock currently trades at $14.50 per share. You have the right to buy it at $17.50 per share and you paid $2.06 per share for this right. Thus, your breakeven point is $19.56 per share.

If GE stock trades between $17.51 and $19.56 per share when the option expires nearly two years from now, you will suffer some loss of capital. If GE stock is trading below your $17.50 call strike price, you will have a 100% loss of capital. Hence, the position only makes sense if you believe that GE will be worth substantially more than the current market price, perhaps $25 or $30, before your options expire.

Say you are correct and the stock rises to $25. You could call your broker and close out your position. If you chose to exercise your options, you would force someone to sell you the stock for $17.50 and immediately turn around and sell the shares you bought, getting $25 for each share on the New York Stock Exchange. You pocket the $7.50 difference and back out the $2.06 you paid for the option.

The Outcome

Your net profit on the transaction would be $5.44 per share on an investment of only $2.06 per share. You turned a 72.4% rise in stock price into a 264% gain by using LEAPS instead of stock. Your risk was certainly increased, but you were compensated for it given the potential for outsized returns. Your gain works out to $54,400 on your $20,600 investment, compared to the $14,850 you would have earned.

Had you chosen the margin option you would have earned $29,700 but you would have avoided the potential for wipe-out risk because anything above your purchase price of $14.50 would have been a gain. You would have received cash dividends during your holding period, but would be forced to pay interest on the margin you borrowed from your broker. It would also be possible that if the market tanked, you could find yourself subject to the margin call.

The Temptations and Dangers of Using LEAPS

The biggest temptation when using LEAPS is to turn an otherwise good investment opportunity into a high-risk gamble by selecting options that have unfavorable pricing or would take a near miracle to hit the strike price. You may also be tempted to take on more time risk by choosing less expensive, shorter-duration options that are no longer considered LEAPS. The temptation is fueled by the extraordinarily rare instances where a speculator has made an absolute mint.

Using LEAPS doesn’t make sense for most investors. They should only be used with great caution and by those who enjoy strategic trading, have plenty of excess cash to spare, can afford to lose every penny they put into the market, and have a complete portfolio that won’t miss a beat by the losses generated in such an aggressive strategy.

The Balance does not provide tax, investment, or financial services, and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

Why It’s Better To Invest In Growth Stocks Over Dividend Stocks For Younger Investors

Dividend stock investing is a great source of passive income. The problem is, with dividend yields relatively low at 2-3% you need a lot of capital to generate any sort of meaningful income. Even if you have a $500,000 dividend stock portfolio yielding 3% that’s only $15,000 a year. Remember, the safest withdrawal rate in retirement does not touch principal. Further, you must ask yourself whether such yields are worth the investment risk.

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 in my humble opinion. 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 16 years, none of them have been dividend stocks. I’m sure dividend stocks will provide over 100% returns if you give them a long enough amount of time. 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, I’m not playing for crumbs. When things turn south, everything turns south so there had better be more than a 3% dividend yield and some underperforming appreciation to compensate.

The following article will attempt to argue why younger investors should focus on growth stocks over dividend stocks in a bull market with potentially rising interest rates. In a bear market, everything gets crushed but dividend stocks should theoretically outperform.

A FUNDAMENTAL POINT TO UNDERSTAND ABOUT 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. Hence, management returns excess earnings to shareholders in the form of dividends or share buybacks. If a company pays a dividend equivalent to a 3% yield, management is essentially telling investors they can’t find better investments within the company that will return greater than 3%. Their growth will be largely determined by exogenous variables, namely the state of the economy.

Pretend you are the CEO of a hot growth company like Tesla Motors (TSLA), the maker of high performance electric cars. Do you think Elon Musk, the actual CEO 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 3% return on its capital. Tesla Motors is up 500% since going public in mid 2020 and now Elon is a multi-billionaire.

Lets look at a telecom company like AT&T (T) which has the largest wireless network in America. Mobile phone penetration is over 85% in America according to Pew Research, and AT&T has the largest subscriber base in the industry. The opportunity for accelerated growth is low, but the cash flow generation is high since AT&T is like a utility. As a result of strong cash flow and no better investment alternatives, AT&T pays a fat dividend of $1.80/share, equivalent to a 5% dividend yield with the stock at $35. Since the 2009 bottom, AT&T has risen 50%, UNDERPERFORMING the S&P 500’s 140% rise.

Tesla vs. AT&T Over Two Years

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. A $10,000 investment in Tesla in 2020 is now worth close to $50,000. A $10,000 investment in AT&T in 2020 is now worth $10,300, a terrible 3% return. But wait you say! If we add on the average dividend payment of 4% for the two years, we’ve got about a 11% total return in AT&T vs. a 500% return for Tesla.

Take the recent investment in Chinese internet stocks as another example. It would take three years of 3% dividend collecting to achieve the 10% return in one month assuming the stocks don’t grow. For VCSY, it would take 1,666 years to match the unicorn! Now of course the dividend stocks should also grow in a growing market, but so should growth stocks so we can effectively cancel the two out.

EVERY COMPANY HAS A LIFE CYCLE SO BEWARE

One of the greatest growth stocks in history was Microsoft (MSFT). But as you can see from the chart below, Microsoft hasn’t moved much since 2003. If you were a young lad who decided to buy dividend stocks in the 1980s instead of Microsoft while you had a chance, you’d be kicking yourself 20 years later. Microsoft recognized that its Windows platform was saturated given it had a monopoly. Meanwhile, PC growth was stalling out so only then did they start paying a dividend in January 2003.

As a dividend stock, Microsoft is not bad with a

2.8% dividend yield. They clearly have tons of cash on the balance sheet and a very sticky recurring business model. The problem is that with a company so big, it’s hard to grow faster than the market anymore. Only since about 2020 has Microsoft started performing again.

Historical chart of Microsoft

What’s scary is that many companies have very short life cycles. 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 forever. You’ve got to stay on top of your investments at least once a quarter.

DIVIDEND INVESTORS SHOULD WORRY ABOUT RISING INTEREST RATES

Dividend yielding stocks, REITs, and bonds will underperform the broader stock market in a rising interest rate environment. The Fed is set to raise interest rates another three times in 2020, and perhaps a couple more in 2020. The reason is simply due to opportunity cost. The REIT that was was attractive with a 5% dividend yield when the 10-year bond yield was at 2% is no longer attractive when the 10-year bond yield is also at 5% because the 10-year bond is risk-free. Risk assets must offer higher rates in return to be held.

To give you a better understanding of how rising interest rates negatively affect the principal portion of a dividend yielding asset just think about real estate. If 30-year mortgage interest rates suddenly climb from 4% to 6%, there is going to be a serious slowdown in demand for new homes because of affordability reasons. As a result, home appreciation will slow or even decline to get back to supply/demand equilibrium. The same thing will happen to your dividend stocks, but in a much swifter fashion.

Of course there are always tactical opportunities in oversold situations.

Example of a municipal bond fund with a 7%+ yield at a 12-month low due to rising rates

YOU’VE GOT TO BUILD THE NUT FIRST

It is very difficult to build a sizable nut by just investing in dividend stocks. (Read: Build Your Financial Nut So Contributions Matter Less Over Time) The words “dividend growth stock” is almost an oxymoron because the larger your dividend grows the more it means management cannot find better use of its cash. Some people mistakenly take “dividend growth stocks” to mean these are growth stocks with growing dividends. There might be some companies with such qualities, but that is a conflicting statement as we’ve learned above.

Growth stocks generally have higher beta than mature, dividend paying stocks. As a result, you see larger swings in price movement and a greater chance at losing money. But for someone in their 20s, 30s, and even 40s it’s better to go a little farther out on the risk curve for more return because you’ve got more time to make up for any losses.

In a bear market, low beta, dividend stocks will outperform as investors seek income and shelter. Clearly we are not in a bear market yet, but who knows for sure. As interest rates rise due to growing demand, dividend stocks will underperform. They may even get slaughtered depending on what you invest in. You’ve got to decide how defensive and offensive you want to be.

If I think there is an impending pullback, I sell equities completely. I’m not a fund manager looking to outperform a down market by losing less with dividend stocks. I’m an absolute return manager looking to not lose any money, period and so should you. We retail investors have the freedom to invest in whatever we choose. Many funds have limits of 3-5% maximum cash holdings so they are forced to rotate into defensive names.

Netflix is one of the best performing growth stocks

FINAL POINT: YOU SHOULD ALREADY BE DIVERSIFYING OR DIVERSIFIED

If you read my recommended net worth allocation by age and work experience post, you’ll see that 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 like CDs. If you follow such a net worth split, then you already have a healthy amount of assets that are paying you income.

If you decide not to diversify your net worth and go all into dividend stocks, it’s possible to replicate such income, but it will be hard. You’ll also be in for some sleepless nights when the markets turn. The gross rental yield on my main rental property is 8%. Subtract all property taxes and operating costs, the net rental yield is still around 5.5%. Only names like AT&T can come close to matching such a dividend yield, and it’s doubtful AT&T will grow as fast as my San Francisco rental property with a surge of new companies and jobs in the Bay Area.

A lot of young folks are so excited about the initial stage of a portfolio’s growth because each contribution is a good percentage of the portfolio. If you’ve only got a $50,000 portfolio and you add $2,000 a month for a year, you’ll likely have around $70,000-$80,000. A 40%-55% growth in your portfolio is great until you realize it’s your savings contributions that provided most of the growth. Eventually you will hit a wall.

Heavily overweighting dividend stocks is a fine choice for those who have the capital and seek income within the context of a stock portfolio. Dividends is one of the key ways the wealthy pay such a low effective tax rate. But before you deploy a large dividend stock strategy, you’ve got to make your money elsewhere first!

TO RECAP GROWTH VS DIVIDEND INVESTING

1) It’s very difficult to build a sizable financial nut with dividend stocks because management is returning cash to shareholders instead of finding better opportunities within the firm to invest.

2) Dividend stocks tend to underperform in a rising interest rate environment. Think what happens to property prices if rates go too high. Demand falls and property prices fall at the margin.

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, CDs, and other income producing assets. Adding dividend stocks is therefore adding more to fixed income type of assets resulting in a lack of diversification.

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. A $100,000 dividend portfolio will only yield around $3,000 in income a year.

5) Dividend stocks are fantastic for older investors who want to generate lower taxed income with potentially lower risk. If you think we are heading into a bear market, losing less with dividend stocks is a good strategy if you want to stay allocated in equities. Rebalancing out of equities may be an even better strategy.

WEALTH-BUILDING RECOMMENDATIONS

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Author Bio: Sam started Financial Samurai in 2009 to help people achieve financial freedom sooner, rather than later. He spent 13 years working in investment banking, earned his MBA from UC Berkeley, and retired at age 34 in San Francisco in 2020. He enjoys being a stay-at-home dad to his baby daughter and 3 year old boy.

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1 ) With interest rates plummeting to all-time lows due to coronavirus fears, Sam recommends refinancing your mortgage. Check out Credible to get free, real quotes from pre-screened lenders competing for your business. Sam prefers Adjustable Rate Mortgages and recently refinanced to a 7/1 ARM at 2.625% at no cost.

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3) Finally, with mortgage rates at all-time lows and volatility in the stock market, Sam suggests investing in real estate due to its defensive characteristics. Fundrise is his favorite real estate crowdfunding platform. It’s free to sign up and explore.

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Thank you very much for this article. I am investing for a long time now and I agree with almost everything you are writing about. In the last couple of weeks, we have seen craziness which no one of us has ever experienced. These times show, that no investing strategy is safe all the time. BUT, it is a good time for us to prepare for future opportunities. Many of the best opportunities start in a bear market or in corrections. Be careful, learn, be prepared and safe all of you! Tom

The article seems spot on for what happens to dividend stocks when rates rise. Investors are seeking out dividends as alternatives to bonds due to low rates and if rates rise, bonds will also suffer, but you have 30% recommended for a portfolio. Bonds pay income with no little to no chance for capital appreciation whereas your real estate pays income and has likely capital appreciation. The real estate has the added advantage of rising rents over time. What do you think of substituting real estate for bonds? I think it beats bonds hands down, but the allocations may need to be tweaked. I just hate bonds at these levels.

Brian Kehm says

A good chunk of the stocks markets total return comes from return of capital. Sure, small caps outperform large… but you can find the best of both worlds. I like to stick to the Warren Buffett investing methodology.

Late to the thread, but we have started using high-dividend etfs as about 10-20% of a portfolio that is short term (6-12m) and used as a holding spot for funds to buy RE. This may or may not be smart given the 15% capital gains, but it seems to work better than putting it in 0.01% interest bearing bank account. Anyone else do something like this? – FS

Money ‘n’ Business says

Not sure how you can argue for dividend investing if you only have $110,000 at the age of 31. There’s no way to retire in 9 years at your pace. Just do the math. If $110,000 is your entire net worth then you are definitely underperforming for your goal.

I’d like to know how to invest. I don’t make a lot of money. $25,000 a year, but would invest $100 a month for retirement and also just to leave my kids something. I have Twitter, MCD, PG in my portfolio. I am learning this investment

Hi Sam,
I am in my late 40’s and do not make a whole lot of money at my day job. That being said, I recently inherited about 100k and was looking to invest it. I should also mention, that I have about 75k in a traditional IRA. I am willing to take on some risk… and was wondering if you or any of your readers, have any suggestions. I have spent the last year or so, looking at mostly US based stocks and specifically those that have performed the best over the past 3, 5 & 10 year time periods. I have made a few small investments in Apple, Chevron, Johnson & Johnson and Disney, through a friend that is a Broker. They were based mostly on his Company’s recommendations rather than on my own research. The investments have done OK, but I feel the need to add some more quality companies as well as maybe some Dividend Stocks, due to my age and lack of Financial knowledge. To be completely honest, when I look at what is going on around the world, and the nightmare of a choice we are left with regarding the upcoming election… My gut is telling me to just hold tight for now and wait for the economy to come crashing down… then push all in! I don’t know if that sounds crazy, but it just seems that every 7 to 10 years, the market gets crushed… and I feel like its screaming high right now, especially relative to what I see on the news. I don’t want to sit on the sidelines forever, but I keep thinking that if I wait for the inevitable down turn, and then invest about 4k on each of the 25 best performing stocks (over the last 10 years) that I could make somewhat of a killing compared to anything I could come up with on my own or in any Dividend stocks. Any thoughts or advice, would be greatly appreciated! Thank You in advance… I look forward to any and all responses!

I strongly recommend holding tight for AT LEAST a month, if not three months whenever you get a windfall. Don’t let the cash burn a hole in your pocket. We are also at the top of the real estate and stock market cycle, so what’s the rush?

I would research various investment strategies. Once you are comfortable, then deploy money bit by bit.

Thanks Sam…
Will Do! I appreciate the quick response and advice!

No problem. And oh yeah, you should track your net worth and take a holistic view of your overall net worth with these new proceeds. That which you can measure, you can improve.

Once you see the $100K in relation to everything else, you can make a better decision.

Christopher Banacka says

Glad i found this post.

Almost 30 years old, and i dump around 50% of my income to 401k, IRA and ESPP (which are sold for around 30% gains, and reinvested into a retirement account since IRA and 104k are maxed)

I have been debating where to start throwing my money, and i have started up a bit with lending club, and vanguard index funds, but most of the hype and youtube videos i see, are people praising divide stocks, and how you can “reinvest that free money back into the stock for more free money!”
But in my head it didn’t add up, mainly because i knew during a dividend payout, prices generally drop by that much.

All this info here really cleared things up. I think i not put any more than like 5% if anything into dividend stocks/funds. And even more so, stay away from those “growth dividend” funds

I appreciate your argument about how certain dividend stocks will never be able to to match the returns of high growth stocks such as Tesla. I used to think the same way you do about a stodgy stock such as AT&T (T). However, your calculations of returns of AT&T above are way, way off. For example, you stated that the return of AT&T between the 2009 market low and June 3, 2020 was only 50% and compared this against a return of 140% for the S&P 500 Index. However, you did not account for reinvestment of dividends. At one point during 2009 the dividend yield of AT&T was close to 7.6%.

According to Yahoo Finance, if you had reinvested dividends in AT&T during this time period, the total return on AT&T would have been about 106%, not 50%. Obviously this is still less than the return of the S&P 500 Index over that time period, but the return of AT&T is more than twice what you indicated above.

Moreover, you also failed to account for the fact that AT&T is far less volatile and declined less than the S&P 500 Index did during the great recession. I am posting this comment before the market open on November 18, 2020. The total return (accounting for reinvested dividends) of AT&T over the past ten years between market close on November 18, 2005 and today is about 131%, which is greater than the total return of the low-cost S&P 500 Index ETF (accounting for reinvested dividends) of about 101%.

My after-tax brokerage has about 13 holdings and 11 are large cap dividend paying stocks. I’m in my low 30’s so I guess I’m young :-). I’ve calculated on a spreadsheet that these holdings will only pay almost a 3% annual return in dividends. What would be your advice on how I can strategically balance the composition of my portfolio to acquire more growth-oriented stocks and in today’s volatile markets? Thanks in advance for your response.

“You do not buy REITs and dividend yielding stocks in a rising interest rate environment.”

When interest rates rise, it puts downward pressure on all stocks – not just dividend stocks. Or do you mean dividend stocks tend to be affected more?

Duane Brinas says

Regarding the 30/30/30/10 rule. For someone in the 30-40 age group. Will 48/12/30/10 work out. (48:12 =80:20 stocks:bonds)?

I am a recent retiree. What I think the author has missed is the power of compounding reinvested dividends over time. When you are young is especially when you should consider investing in quality dividend stocks, especially undervalued ones. Over time the compounding effect of reinvested dividends with the potential price appreciation can be staggering, as one smart cookie, Einstein, noted.

Your comments seem to have substance and it’s obvious you are well informed and educated in finance. I am not. However, back in 1996 I invested a small amount (I think it was 3300 dollars in a micro- cap mutual fund, if I remember correctly, I bought a 100 shares at $3.30 per). I mentioned *I think* because it was so long ago and I don’t have my records with me. However, *I KNOW* its within a few cents plus or minus. I had the dividends reinvested. The fund is at $8.24 right now as of yesterdays close. Because of the dividend reinvestment, I now have about 6500 shares which puts a better than $50,000 return on a $3K investment. Although its been almost 20 years, I still think that’s not a bad deal. I kick myself for not investing 30K instead of 3K. For this reason, I don’t think your advice is all inclusive. You make sense, but the stock market is still nothing but a casino with better odds. By the way, I picked that mutual fund by closing my eyes and putting my finger on the financial page of the paper, with the resolve to buy whatever it landed on………………

Thanks Sam, this is very interesting. I’m still trying to figure out my own investing strategy. I’m fairly new to this whole early retirement scene…

One thing I’m curious about is how you recommend to handle taxes. As I understand it, with a dividend growth portfolio you would never realize the gains and hence pay no taxes on the gains.

If you first grow and then rebalance to more yield returning investments, you will have to realize your gains at some point along the way… I assume ideally you would prefer to do that in a slow and steady process after retirement, but when you deal with growth stocks you might also want to protect your gains by setting stop losses which could then create a huge taxable event on some random Friday morning…

Sam, i would like your personal email? i have a question to ask

Interesting article for a young investor like myself. I’ve started out mainly investing in established dividend paying companies like AT&T and Altria, thinking that they will be around for a long time and I can set my positions to DRIP and forget about them.

I’ve been reading a lot of the classic value investing Graham/Buffet stuff and was wondering what are the best ways to tell apart a highly speculative stock like Tesla, from a legitimate growth investment opportunity?

Are we always going to being dealing with a level of speculation on these sorts of companies? Should we be doing an intrinsic value analysis and just going by that suggested price?

Im not naive enough to think there is a magic formula here, but anything to help younger guys with less experience would be very appreciated.

Charles | Loans for People on Benefits says

High dividend is important but it comes at a risk, I was been holding Pitney Bowes for a while and managed to receive over 10% for an extended period of time, I was able to escape before they cut their dividends and stock plunged. I guess the moral is you need to strike a balance between growth and dividend otherwise you’ll get into trouble eventually. This is a great post, thanks for sharing, really detailed and concise.

Shobir | Find Some Money says

There are some great examples here. Is there any way to hedge the dividend payments? I’ve not done a lot of research into this however I was thinking about buying the dividend stock and then selling a call option, if the stock did rise then the call option would rise in value and I would make a loss but still get a dividend payment. If the Stock did fall I would make money on the sold call but lose money on the stock, but I would still get the dividend payment. Has Anyone tried a strategy like this? Does one exist?

Interesting article, thanks.

I do think there is something to be said about taking additional risk when you are younger, but I think proper diversification is critical. I don’t put all of my eggs in any one basket nor strategy. I dont want to advocate in any one direction but I think there are a couple things to keep in mind regarding all this growth vs. income bologna:

1.) You are flat out wrong if you believe a 25-30 year old investor who makes monthly contributions to a boring dividend portfolio will struggle to reach financial independence by retirement. Run the numbers on $2,000 a month with a 4% starting yield, 7-8% annual dividend growth and a measly 5% share price growth for 20 years and tell me what you come up with? I’ll give you a hint its $1.6MM and the portfolio is spitting off $100,000/year without ever selling a share. And you may not even be 50 years old yet. If you have a shorter time horizon or you want to live your life like a Lil’ Wayne music video, the whole thing is more difficult. But as anyone knows, time is your most valuable asset. Since we have a hard time with basic math lets use Laquinta Growth’s friend as a working example. $90,000 by 29 is nothing to sneeze at. Again, if total contributions are $2,000/mo with a 4% average dividend yield, 8% average dividend growth, and 5% price appreciation by age 45 his buddy will have a $1.3MM portfolio and it will be paying $75,000 in dividends. I dont know what part of the world you all live in but that is already substantially higher than the average household income.
2.) I am going to go out on a limb and say maybe 5% of the people reading this blog will ever actually pick “a 10-bagger”. I thought at this point it’s pretty much proven that trying to go out and pick high flying stocks or a 100% aggressive growth strategy flat out doesnt work. Over the long term, dividends have been critical to total return. From the end of 1929 through March 2020, reinvested dividends provided almost half of the S&P 500 Index’s total return, or a 9.4% annualized return versus a 5.2% return for price appreciation alone. If anyone wants to bet that they are going to consistantly destroy the S&P over the next 20-years and wants to put their naive money where there mouth is come find me.
3.) “No hedge fund billionaire gets rich investing in dividend stocks” – this is the most rediculous and erroneous comment. A wise man once said “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.” He doesnt run a “totally awesome hedge fund” but guess what, he did alright with lame slow growth dividend stocks didnt he?

I invest all over the place; growth stocks, dividend stocks, “evil over priced bonds”(heaven forbid!), REIT’s, etc. There are merits to all strategies, and I think the overall missing ingredient is someone’s dedication to their chosen strategy. You go after something with 100% conviction in anything in life you’ll be successful. The problem people have is staying the course and remaining committed. Stay thirsty my friends….

Jon, feel free to share your finances and your age.

I write this post based off my own experience where I’ve developed a financial nut that generates over $100,000 a year in passive income now, which does include dividends before the age of 35. I couldn’t have gotten there if I didn’t invest in growth stocks over the past 13 years.

Please provide your story so we can understand perspective. I’ve found that there is a dividend investing bubble with so many people who are not financially independent pontificating why dividend investing is the greatest strategy on earth. I do like the strategy. I just don’t think it’s going to help those who want to reach financial independence before the traditional retirement age.

I can’t disagree with you that if you are trying to be financially free by 35 you are going to have to get way more creative with how you approach your investing strategy. If you are already generating $100,000 a year passively I commend you for reaching such a feet. Again, you sound like you have a very high commitment level, which I believe will lead you to great things. Unfortunately your story is the exception, not the norm. I am in no way advocating being “normal”, in fact most of the readers here are probably far from it. This is great, but the long stick of reality is a tough one when we’re talking extreme early retirement. This isn’t to discourage anyone, but realistically if you are trying to retire in 10-years it doesn’t matter if your annual returns are 10% or 50%. You’ll need aggressive measures.

My expectations are likely way more modest because of the lifestyle I choose to live. I didn’t start my career until I was 24 and worked your typical office job that everyone hates. I am 30 now, and I’ve very gradually had to move my way up. My household income is probably more than most ($200k+) but I also spend my fair share trying to keep some semblance of balance. I save what I want, but I most certainly could do more. I am well aware of my shortcomings and things don’t happen overnight. Total readily investable assets are probably in the neighborhood of $350k. Could I get lucky and double down on the next Apple or LinkedIn? I could…and I’m young so if things go sideways I could always start over.

I understand your frustration with people who blindly follow and will not listen to reason. Dividend investing isn’t the greatest thing ever invented. It’s simply 1 of many tools you may want to have in your bag to make things work. As I mentioned in my first post I wouldn’t ever advocate putting 100% of your savings into anything. Real estate developers are notorious for this. But when incorporated appropriately can be another very powerful income generating tool.

Again, congrats on the success, keep it up. I just don’t want people to avoid one particular approach all together because they are only looking 5-feet in front of them.

Thanks for sharing Jon.

What it boils down to is risk, reward. You can reach early financial independence without taking risk. So if one is saying in going to retire early and live well of dividend investing, it’s probably not going to happen.

It’s probably not going to happen blindly swinging for the fences either. But, at least there is a chance. It gets harder to take risks once you’ve built a financial but it are too old to want to start over.

Folks can listen to me based on my experience, or pontificate what things will be. All is good ether way!

While I do agree with many points in your post, I still do think dividend growth investing can be a great and lazy way to secure extremely early retirement. Much like yourself I am not part of the norm, and have had a rather generous paying career at a very early age (22), and I am 24 right now investing in soley dividend growth stocks. 2 years ago i didn’t even know how DRIPs worked, let alone invest, a year and a half ago i bought my first share which was RIOCAN. I intend on staying true to this investment lifestyle and yes I do believe I will accumulate enough wealth to reach FI in my 30s (only had a NW of $16k and now currently have $134k invested in dividend grwoth stocks churning out about $5.5k yearly). I am now at a level where my rent can be covered on a monthly basis by my dividends alone.
Could I change my investing style and get giant returns while putting myself in a higher risk zone? Absolutely. But one thing is certain and that dividend growth investing is one of the most passive (laziest) ways to build wealth. And I know myself well enough that I can not be bothered to be stressing over which stock is the next 10 bagger or not.

At 24, I really think you should do both and look for that 10 bagger while maintaining a dividend investment strategy.

You just started investing in a bull market. It’s important to know that it’s not always good times! Diversify!

You make an excellent point about dividend stocks being mature companies with slower growth and therefore dividend payouts to shareholders. Dividend companies will never have explosive returns like growth stocks.

Younger investors investing for a 3-4% dividend yield are misallocating resources and their portfolio amounts after 5, 10, 15 years shows this. Dividend investing is easy because there’s less risk and all the names like Coke and Walmart are out there. Doesn’t take mug analysis or brain power so you can’t fault younger investors for just sticking with this strategy.

No hedge fund billionaire gets rich investing in dividend stocks.

LaQuinta Growth says

I thoroughly agree with you on investing in growth stocks and looking for higher reward names while you are younger.

It’s perplexing to hear investors under 30 or even under 40 predominantly focus on dividend stocks if they wish to retire early. One guy I know is 29 years old and is a dividend investor with only a $90,000 portfolio. He says he wants to retire by 45 at the latest and there’s just no way if all he could amass is $90K after 7 years. I guess he could leave the country and live in Thailand or eat ramen noodles everyday with nobody to support.

Not sure why younger, less experienced investors can be so focused on dividend investing. Maybe because it is so easy and their knowledge is limited?

Sam, while I agree with your general comment that the capital returns on larger dividend stocks are likely not as significant as growth stocks, an investor can easily make a total return of 10% plus consistently by buying these stocks steadily overtime with minimal stress. In my view, this is very important when you are a young investor. Steady returns at minimal risk. Growth stocks are high beta, when they fall they fall hard. Its like riding a roller coaster. Give me a McDonalds any day over a Tesla.
The best of both worlds are small/mid caps stocks that pay dividends. Thats really my sweet spot. I get close to $9k of my total $27k in annual dividends from this group of payers. They give me capital growth and income growth of close to 20-30% per year. Probably $200k of my cash is tied up in these companies. Unfortunately exposure to these types of stocks isn’t readily available in the US market, they’re plentiful down under though!

I think we just have a different view of risk as i disagree with your statement “Very important when you are a young investor. Steady returns at minimal risk.” Chances are that one will never be able to achieve a big enough financial nut through growth stocks. But I can assure you that chances are practically zero a dividend investor will ever find the next Google, Apple, Tesla, Netflix, Microsoft etc because these stocks never focused on dividends during their growth phase.

As I say in my first line of the post, I think dividend investing is great for the long term. It’s just suboptimal for younger investors who are looking to achieve financial freedom sooner. A 10% total return is nice, but if the financial nut is small it doesn’t move the needle. Your $27,000 a year is great after a nice bull market, but what is the inflation rate, risk free rate, and the past several years of broader market returns in Australia? We need to compare apples to apples. Where else is your capital invested is another important matter beyond the 200k.

I’m planning to start investing after I turn 18 and this post really taught me a valuable lesson when it comes to investing in stocks, specifically whether to invest on growth or dividend stocks. I will surely consider buying growth stocks than dividend ones. Thanks!

Mark, just remember, RISK and REWARD. There’s very few cases where there is a lot of reward with little risk. You can and WILL lose money. Investing is a lot of learning by fire. But if you never get up and swing, you will never hit a homerun.

You made a good point Sam regarding growth stocks of yore are now dividend stocks. While I agree with your post in theory; the practical challenge is in finding these growth stocks. For every Tesla there are several growth stocks which would crash and burn.

Isn’t it better to invest in the index and the ride it out. I’ve lost a ton of money in trying to find these elusive growth stocks consistently.

I’m an advocate of allocating the majority of your exposure to whatever index you choose. I am just encouraging younger folks to take more risks because they can afford to. Focusing on dividend stocks and bonds in your 20s and 30s is suboptimal. Yes your companies have less of a chance of getting crushed, but the upside is also less as well.

I am new to managing my own money and just LOVE your blog! You explain everything in layman’s terms! What do you advise in terms of TIPS since inflation is inevitable with the flow of money in the economy? I love this article about dividend paying companies- makes sense. Keep up the great work and all the research you do!

Welcome to my site Chris! Always good to hear from new readers. Make sure to sign up on the top right corner via RSS or E-mail.

TIPS is definitely a great way to hedge against inflation. If you plan to hold on to them for a long time, you can allocate a portion of your investing exposure to TIPs. I just don’t think there is that much value in bonds at all, and the only reason why I would buy bonds is for tactical hedges (instead of shorting this crazy market).

Thank you so much for posting this.

You just answered a large chunk of questions I had the other day

Now I still want to know if you think it’s too late to get in on Tesla? Do you think there is still more upside there? If I had a chunk of change to put into a potential multi-bagger today would it be a good idea to put it into Tesla?

I would think Tesla has maximized its run for now as they have to now execute and prove they are worth their $100/share. I’m personally looking for the next Tesla.

Thanks! Now I can divert my attention elsewhere lol
I have my eyes peeled for the next and I’m finding it utterly difficult to focus at work while I research stocks/companies!

galactic merchant says

you were horribly wrong about tesla lol

Bought at $88, sold at $380 and $320. That’s not bad for five years.

Too bad now it’s struggling, but it’s still much higher than $8 in 2020. Not sure what you are talking about.

Hopefully the FS community here has gone beyond the core fundamental of aggressive savings in order to achieve financial independence. If not, maybe I need to post a reminder to save, just in case.

I like your “not going broke with Coke” comment. It’s a defensive strategy which plays not to lose. Again, perfect for risk averse people in later stages of their lives. I treated my 20s and early 30s as a time for great offense. A go for broke, play to win strategy. I have lost money many times, but I’ve also found great returns with this mindset.

Eventually we will all probably lose the desire to take on risk. I encourage younger folks to take full advantage of their youth because we’ll get old before we know it.

My strategy is to build the nut with private business and look to convert that to passive income via dividend stocks later in life. There is no greater way to achieve wealth than by private business, they can be bought at lower multiples and there is not a need to have percieved value to realize gains like stocks. Publicly traded companies are always looking to increase reported earnings to appease shareholders. Private companies look for areas to “hide” earnings to lower tax rates I.e. bonus depreciation, cash basis accounting.
Great site!

Love your last sentence about hiding earnings. So true! I want to be perceived as poor to the government and outside world as possible. You’ve got the exact right idea I’m trying to espouse. Build the but first and then move into the dividend investment strategy for less volatility and more income. Not the other way around.

I think you’ll enjoy these posts:

I didn’t say there are no capital gains with dividend stocks. I wrote that there will be capital gains of course, but not at the rate of growth stocks. Everything is relative and the pace of growth will not be as quick in a bull market.

Dividend stocks are great. It’s not optimal for those who are trying to reach financial independence at a quicker pace. The question is, which is the next MCD?

Sam, I understand the premise and agree your risk curve should be higher when younger, but do you suggest to buy specific targeted mutual funds or to do the research yourself and pick individual stocks? I tried picking stocks a long time ago, but the more I learned about how businesses operate it became increasingly obvious I had no clue what I was doing. It always amazes me that a so-so public company can trade at 15 times earnings and people will sink a ton of cash into a single stock (I understand the whole liquidity aspect)…but small profitable good companies can be purchased for 4.0 – 5.5 times earnings. Your point about Enron, Tower, Hollywood, etc. really hits home & that’s why most of my free cash flow (since my nut is covered already) goes towards buying stuff you can touch & see like real companies or real estate.

There are a couple premises:

1) A growth strategy, be it in growth strategy funds, index funds, or stocks are worth the risk while you are younger and can stomach more risk.

2) It’s worth putting in the effort to care more about your investments than anything else, instead of just setting it and forgetting it. Don’t mindlessly “invest” in stocks or funds without understanding what you are investing in. Empower ourselves with knowledge. We spend more time trying to save money on goods and services than investing it seems.

A dividend growth stock investment strategy attempts to find companies that are already experiencing high growth and are expected to continue to do so into the foreseeable future.

Those are some really helpful charts to visualize your points. Wow Microsoft really leveled off when you look at it like that. I have a good amount of exposure in growth stocks in my 401k that have been treating me pretty well.

Microsoft has really been dead money for the past 10 years, and it’s looking more and more like Apple might fall the same fate if they can’t innovate.

Agree with you- my strategy has been shooting for multibagger stocks early on and later on plan on reinvesting the proceeds in dividend ETFS (VIG And VNQ) to supplement income from other sources. So far I’ve more than doubled my initial investment in the past couple years, much more than the meager returns offered by dividend stocks.

Nick, it’s the strategy I used in my 20s and by the time I hit 30, my 401(k) alone was over $250,000. Who knows the future, but more risk more reward and vice versa. It’s easier to take more risks when young. Good luck!

Cory Swartzlander says

Sam, I agree with your overall assessment for younger individuals. However I don’t think your comparison of Tesla to AT&T is fair or a good one.
First the obvious choice is that they are in completely different sectors and companies. So compare Tesla to say Ford, GM, or even TATA. Yeah the returns are still not very close but that does show the difference in growth vs stability/dividends. Which is why I agree with your point.
Second Telsa could very easily fall back down in the next few weeks just as fast as it went up. This is obviously a risk you are taking in a “growth’ stock. Taking Tesla, I personally don’t think Musk(CEO?) will let it fail and will do everything in his power for electric cars to succeed, but we can’t say that about all growth stocks. Some companies in growth phases grow to fast and end up going bankrupt and getting bought up.

Overall I do agree with your assessment in this article.

The Tesla vs T is just an example. The argument is that if you are looking to accelerate your financial freedom, then you’ve got to take more risks. It is a paradox to try and achieve early retirement through dividend investing b/c it is very hard to build a large enough financial nut.

Folks have to match expectations with reality.

I think you’re just saying to take more risks when young, which makes sense. More risk means more reward given such a long investing horizon.

Dividend stocks act like something between bonds and stocks. While stock prices fluctuate rapidly, dividends are sticky. Dividend growth has only been negative 7 times since 1960. Dividends fell 20% in 2009, but the next largest decline was 3% in 2001.

I mostly invest in index funds, like VTI. My dividend income is more than my expenses, but only because I have earned a lot of money during the past 10 years with my business.

I couldn’t disagree more. Total returns are derived from both capital gains and dividends. Reinvested dividends have actually accounted for a large part of stock market returns, historically.

Per the famed John Bogle:

“An investment of $10,000 in the S&P 500 Index at its 1926 inception with all dividends reinvested would by the end of September 2007 have grown to approximately $33,100,000 (10.4% compounded). [Using the S&P 90 Stock Index before the 1957 debut of the S&P 500.] If dividends had not been reinvested, the value of that investment would have been just over $1,200,000 (6.1% compounded) – an amazing gap of $32 million. Over the past 81 years, then, reinvested dividend income accounted for approximately 95% of the compound long-term return earned by the companies in the S&P 500.”

And that’s coming from Bogle himself, the founder of Vanguard..who is obviously not pushing dividend stocks, but rather index investing. And yes you read that right. 95%. Or almost all of the long-term return.

Sure it’s easy to compare AT&T to Tesla. You have a quasi-utility up against a start-up electric car company. Apples and oranges themselves couldn’t be further apart. Not only that, but if you would have done that comparison just four or five months ago it would actually have been pretty close, which is quite disappointing if you’re a TSLA investor. Speaks to the importance of time periods when comparing stocks. TSLA is up over 141% over the last 3 months. Besides, investors in AT&T aren’t looking to set the world on fire. They’re looking for stable income. And speaking to your 3% number you keep mentioning, AT&T yields 5%. That $500,000 nut then spits out $25,000 in yearly income at that level. Not so bad now.

Let’s take a look at McDonald’s (a boring snooze-fest of an investment). They cannot grow much because they’re returning so much to shareholders. Or can they?

MCD over 10 years: up over 366%
S&P 500 over 10 years: up over 68%.

And that MCD performance is before reinvested dividends. Which is really at the heart of all of this.

I’m not investing for “3%”. I’m investing for 3% (or more in many cases) that’s growing by 7-10% or more yearly. That 3% then turns into 3.3%, 3.7%, 4.1%, 4.5% and so on and so forth. And since the market is pricing these stocks at the “3% yield” you mention, the stock price goes up in tandem to price the shares accordingly. That’s why MCD shares aren’t $20 per share yielding 15%.

Looking beyond “the measly 3%” is important. You’re buying a piece of a high quality business that will grow earnings and send out a portion of those earnings to shareholders, which they can then reinvest back into the business. It’s a wealth compounding machine that almost greases itself.

But, the less for you means the more for me. And I’m happy to buy them all up! :)

Good to have you. Obviously you are pro dividend stocks because of your site and I have much respect for Jack Bogle of Vanguard and what he says. I also appreciate your viewpoint.

Lets just look at the numbers and situation:

* You are 30-31 and want to retire by 40 with a plan to live off your dividends.

* Your dividend portfolio is

$110,000 currently, yielding $3,000-$3,500 a year. You make no mention of a 401(k), so I’m assuming the $110,000 is it and a majority of your net worth. Please correct me if I’m wrong.

* How do you plan to build your portfolio to a sizable nut within 9-10 years and retire through dividend investing as the main strategy and nothing else? Where do you think your portfolio will be in the next 9-10 years? 5X what you made in the first 9-10 years?

If you want to put all $500,000 into AT&T stock for a 5% dividend yield, be my guest, but that’s still only $25,000 a year to live when you’re 40 which is probably equivalent to $20,000 or less in today’s dollars. Let’s forget about predicting the future and just look at what’s transpired. Using a growth strategy in my 20s has led to a 401(k) valued around $250,000 by age 30 and this was by saving less every month than you are contributing now b/c of the 401k contribution limits. My 401(k) was also shackled by a limited selection of funds and no growth stocks to specifically pick.

You’ve got to admit the difference of $150,000 between the growth portfolio and your dividend portfolio at 30-31 is significant. And again, these are just the facts, not predictions which can be molded however way that benefits our argument. I’m confident your strategy of aggressively saving and investing in dividend stocks will payoff over the next 30 years, but I have my doubts that it will provide you enough to retire in 9-10 years at your pace based on history. If you were only able to accumulate $110,000 by 31, it’s difficult to see your portfolio grow 5-10X the pace during the same amount of time. I know everybody believes they are Warren Buffett in a bull market, but it’s best to be more realistic.

I really fear young people are going to get to their target early retirement age and realize their assumptions were way off and regret their decisions along the way. I really do hope you prove me wrong in 9-10 years and get big portfolio return. I think a better strategy is to make money online writing about dividends so you don’t need to get that big financial nut. $2,000/month is very achievable after a couple years.

Final point: Compare the net worth of Jack Bogle vs. any of the top 10 hedge fund managers in the world as we are comparing people at the top of the game.

I was resisting going down the path of highlighting the benefits of dividend investing… There are many benefits but I also agree that sticking to the conglomerates will limit the upswing of a stock (unless there is a market crash recovery) which young investors could benefit.

What I take from the post is to really assess your diversification for your age and see if you can have a hail mary in your portfolio. Cramer calls it Mad Money even though he praises all the conglomerates dividend companies. If you take a chance with 2% or 5% that can double than there is nothing wrong but you have to be willing to lose it and it takes nerves of steal to not throw more money into it when you get some hail maries.

I find there are also good growth with many dividend companies as I have a good number in my portfolio that have earned me 50% over the past 3 years. It’s a risk versus reward strategy. I stick to dividends because my downside is limited and I get paid to wait … I won’t elaborate more on my strategy here.

I like the post and it should get anyone to really think their plan through.

Maybe I’m missing something, but isn’t your Bogle example showing that capital gains returned 6.1% over that period and dividends returned 4.3% The dividends are certainly important, but the capital gains are the larger part of the return. Saying that 95% of the return came from dividends is very misleading, because you’re counting all of that extra growth to dividends when it’s really just because the combination of the two leads to a bigger overall return. Dividends actually accounted for 41% of the growth, which is certainly significant but also changes the conclusion.

Not sure how you plan to retire by 40 on your portfolio either. $110,000 is not a lot by age 31.

Not sure how you can argue for dividend investing if you only have $110,000 at the age of 31. There’s no way to retire in 9 years at your pace. Just do the math. If $110,000 is your entire net worth then you are definitely underperforming for your goal.

A 35 year old man who only has $400k saved and had to move to a 3rd world country to make ends meet. Yeah, I really want to follow your advice.

how old are you and how much do you have saved? Also thailand is not a third world country

Does your analysis include reinvesting the dividends?
What if you reinvested all the dividends instead of seeing them as “income” (DRIP model)?

Based on my examples above, I’ve added back the dividends for a total return.

I liked this article, mainly because you referred to people 40 and under as “young”. That made my day!

Well… age 40 is technically the midpoint between life and death!

I will and have gladly given up immediate income (dividend) for growth. I would rather have my stock split and grow vs. dividends which is a little more than bond interest. When I retire, I do plan to increase my allocation of TIPS and dividend paying stocks just to support my withdrawal rate.

Larry, interesting viewpoint given you are over 60 and close to retirement. I wonder if I will feel the same way when I’m 60.

I treat my real estate, CDs, and bonds as my dividend portfolio. So perhaps I will always try and shoot for outsized growth in equities. Thanks for the perspective.

Your real estate can be part of a growth strategy, if you do a 1031 exchange for a larger property. My strategy was increasing value (income) and I gave up immediate income. It was partially a tax strategy and wealth building strategy. Capital gains was lower than my ordinary income tax bracket.

I am a dividend investor and I agree on the many points you are highlighting and more importantly, diversification is key and it’s different based on your age and goals.

A 3% return is a good conservative dividend yield at market prices but over time, if you are carefully choosing your dividend investments, you can grow that dividends. Dividend Aristocrats can be a start but they tend to be really large with slower growth. If you do your research, you can still find companies with growth such as KMB but I agree that the LULU, Netflix or Tesla will rarely exist in such a portfolio.

Dedicate some money for your hail mary. I still believe it’s important you understand what you invest in and do your research. Even for your hail mary.

From a dividend investor I appreciate your viewpoint. I actually can’t wait to building the equity portion of my net worth to a big enough number where it alone can generate six figures in dividend income. Combined I’m there, but the competitor in me wants to see if I can do it with just equities.

Couldn’t agree more. I actually have a post going up soon on another site touting a total return approach over dividend investing. Dividend stocks have been getting a lot of play in the news the past few years, which I think is a big reason so many people are focusing on them. But it’s really just an undiversified approach to focusing on the lower-returning piece of stock returns, and a sub-optimal approach to risk management. Even in retirement I wouldn’t focus on dividend payers in particular. If I want to mitigate risk or have more current income, I’d simply shift my allocation more towards bonds.

I look forward to checking out your post!

The First Million is the Hardest says

It’s also very easy for any investor to shoot themselves in the foot by missing out on steady returns by constantly trying to find the next Amazon or Apple. For every investor that hitched their wagons to Amazon.com back in the late 90’s there were several others who made big bets on companies such as Pets.com.

If finding great growth stocks was easy, we’d all be rich. I have to imagine that for most investors their overall stock returns will be greater sticking with dividend stocks than chasing those elusive multi-baggers.

Not all stocks are created equal, even boring dividend stocks. AT&T may have lagged the S&P500, but my investment in 3M has outperformed the S&P by 21% since I bought it in 3/09.

I think dividend stocks and growth stocks have a place in everyone’s portfolio, how much of each just depends on a persons individual goals.

My point is that if you’re under 40-45 and don’t have much capital, it’s a suboptimal strategy in a rising market to have the majority of your equity portfolio in dividend stocks. What was the absolute dollar value on the 3M return (congrats btw)? Does it move the needle?

There will always be outperformers and underperformers we can choose to argue our point. If folks are glad to spend the traditional 30+ years investing to get to a meaningful financial nut, then great. But for those who want to seek financial independence sooner, it’s hard for dividend investing to take your there.

Young folks are confusing their savings contributions to their portfolio rather than their portfolio’s returns. Separate the two to get a better idea.

Sam, I respectfully disagree with you on this one, I only consider dividend growth stocks that are growing both revenues and earnings while consisitently increasing their dividends above 5% a year. In many ways I look at my stock investments as owning a piece of property, except the property happens to be the best property on the block. Here is a good example of real “divididend” growth investing: From January 2008 to now a portfolio of these stocks (MA, TROW, SBUX, GWW, UNP, & DIS) had a total return (with dividends reinvested) of close to 160% trouncing the S&P 500 total return (with dividends reinvested) of 27%….all this while paying me “rent” that increase more than 5% per year. Sam, I am not saying it is easy, but in many ways people received more pain in the real estate market than holding these great “properties”.

Joe, we can basically cherry pick any stock to argue our case. Perhaps we have to better define what a dividend stock is then.

I’ll definitely disagree with the pain feeling of when people’s portfolios were getting demolished in equities vs. just living in your home and not worrying about the daily price b/c there is no daily price.

Sam, the thing is that I didn’t cherry pick it, I have bought and held these holdings during the housing meltdown and financial crisis, in fact I backed up the truck on some of the holdings during 2009, but let’s say you were right about cherry picking, I would ask you is it cherry picking buying companies such as McDonalds, Proctor & Gamble, IBM, or Pepsico (obviously big blue chip that even Grandma would buy) …Sam even these four (as a portfolio) returned better than a 60% return (w div reinvested)…Remember I said quality properties and obviously you must do some homework. Sam, it may have taken me awhile to learn how to find thes type of companies, but I would bet you it is as easy or hard as finding a great appreciating real estate property.

This is great to hear. Again, I am talking a relative game here. Im not saying dividend investing is bad, on the contrary. im saying for younger folks who whave more time, growth is more optimal.

Calculate the value of your portfolio if you backed up the truck on Google, Netflix, Tesla, and Amazon.

What about VDIGX? Dividend Growth Fund Investor Shares. Growth and dividend’s rolled into one.

There are other dividend paying stocks with great growth records and now that it’s mid year 2020 you can see the crazy results of Visa, Master Card, Costco and others. Many utilities and even Coca Cola looks like a growth stock the last 10 years with 108% increase.

Cherry pick or VDIGX?

I looked into Google, Netflix, Tesla, and Amazon and you have my attention. Visa and MasterCard out preformed all but Tesla. All 4 of your picks would have been great if I bought them in 2020 but aside from TSLA would you say these companies are now “young adults” with the big gains already made and less upside growth? (June 2020)

Anton Ivanov says

True, but the stocks with such high yields aren’t likely to keep them for long. In fact, it’s probably a cause of concern, since their share price may have recently crashed to cause such high yields. If the price decline was due to short-term market noise – that’s fine, but if there are significant underlying fundamental problems, it’s another story.

Overall, I agree with the point of view of the article. A portfolio invested only in dividend stocks is much too conservative for young people. But dividend stocks can be viable for diversification as you get older or as you begin to draw income from your portfolio.

Dividend stocks and REITs have collapsed due to a real fear that interest rates will begin it’s ascension towards normalization, whatever that level is. I don’t think rates are going too much higher over the next 2 years, but they will eventually go up.

Great insight Sam! I wrote something very similar for later this week about how I am leery of dividend payers right now with the speculation revolving around the Fed and rates. I think they have their place in a well diversified portfolio, but you’re right, the younger you are the more you should be leaning towards those growth stocks. This is, of course, assuming you’re doing you’re due diligence and being wise about what growth stocks you’re going into. Even as I am staring down the big 4-0 I am leaning towards growth stocks as I have a pretty high risk tolerance and have been able to do fairly well with them.

Nice John. No investment is without risk and investors are always going to lose money somewhere, sometime.

Good explanation of some differences between growth and dividend stocks, much better than a lot of other stuff I’ve read that just looks at charts and not the reasons behind them. I’m curious though, are there any historical examples or potential reasons you can think of that a growth company might choose to pay dividends rather than investing in R&D or something else?

Yes. When growth slows and there’s no better investment opportunities. Public companies answer to shareholders. Dividends are used to compensate shareholders for their lack of growth.

Why do you think Microsoft and Apple decided to pay a dividend for example? Feel free to write a post and prove me wrong! I always appreciate those.

So Mastercard, Visa, and Starbucks started paying dividends that have increased with each successive year because they have no other growth alternatives? Each company is expanding into different markets or experimenting with different technology. I’d argue that increasing dividends, even low ones like MA and V, is a vote of confidence in their own profitability. Tesla can’t pay a dividend because it’s burning cash like crazy. There’s a difference between speculation and investment. Musk is brilliant, but there’s an irony in the name he chose for his company. Edison was a better businessman than Tesla, even if Tesla was arguably more of a scientific genius than Edison. I’d agree that you’d be insanely wealthy if you accurately predicated and invested in each of these innovative disruptive companies as they emerge, but like you said, it’s incredibly difficult to beat the market by huge leaps like that Tesla example. Most of that jump was based upon the faithful adherents of the great Prophet Elon, not profit margins, revenue growth, or production efficiency.

Another indirect benefit of dividends is discipline. It makes firms accountable and tempers irrational M&As or ludicrous R&D projects.

I’m glad you advocate index funds. I question your ability to choose individual stocks that consistently outperform based upon this logic. Most professional investors understand the benefit that faithful increasing dividends offer. But you’re right if you’re looking for a homerun stock. Problem is that tends to go hand in hand with striking out. I imagine that’s why less than a handful of professional investors can consistently beat the market for any period of time. It’s probably also why the average retail investor vastly underperforms traditional equity returns.

I’m 36 with $700,000 in stocks, rest of my money elsewhere. I’ve owned dividend-payers like Boeing for over 15 years. Never sold and don’t plan to unless they decide to stop increasing their dividend, change their business model, or see their moat threatened. I would go to Vegas before I bought Tesla for even a month. I’m an investor, not a gambler.

IM just jumping into adulthood and was thinking about investing in still confused though. If you invest let’s say $1,000 in a stock and let’s say you have bought 20 shares and only make $0.40 a share every 3 months your making $32 a year which would take nearly 30 years just to make your money back

This my be true. But if you take then dividend and reinvest into the same stock it will take 1_2 that per say the compounding interest. In my understanding. I bought 100 shares. Pays .08 per 3 months 8 bucks a quarter and 32 dollars a year. It take I think I did math. 4 to 6 years to make money back . But if I buy more stocks I’ll make 100 more shares in 2to 3 years

Sounds great. Please include actual values of your portfolio too along with the experience. Helps highlight the case.

Dividend Mantra is a good case study/data point of achieving $110,000 through dividend investing by age 31. $110,000 is fine but it has significantly underperformed my growth focused 401k in the similar period.

The allure is that you don’t have to think as much with dividend stocks as they are usually well known companies with established businesses and large balance sheets.

Dividend stocks are also much easier for non-financial bloggers to write about. Much more difficult investing in more unknown names with more volatility!

You have a very narrow view if you can’t see the message that dividend stocks are mature companies with much lower growth that won’t provide outsized returns.

Do you even have $100,000 in dividend stocks yet at your age? Hope you aren’t some 20-something year old with no formal training, living in the boonies spouting off why your way is the only way to go.

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