Dividend stocks hurt returns but are still very popular
The numbers speak against dividend stocks and for growth stocks, which regularly show higher “total returns.” So, why do investors love dividend stocks so much?
Sell stocks or collect dividends?
Building wealth with stocks and later living off it is often the plan. But how should the withdrawal phase work? Are stocks sold, dividends collected, or both?
Milk the cow, don’t slaughter it
The idea of receiving dividends forever, or at least as long as the company exists, sounds appealing. This way, the stocks would never need to be sold.
Those who never sell stocks also avoid deciding which stocks and how many to sell.
Example: Warren Buffett
Investment legend Warren Buffett’s company, Berkshire Hathaway, does not pay dividends to shareholders. However, the company owns shares in other companies that, in turn, pay dividends to Berkshire Hathaway as a shareholder.
So, while Warren Buffett does not pay dividends himself, he apparently enjoys receiving them.
But does his behavior—collecting dividends but not paying them—argue for or against dividends?
Following Buffett’s lead is certainly not wrong, as he has outperformed the S&P 500 for decades.
To answer whether Buffett supports or opposes dividends, two aspects of his strategy need to be examined:
Buffett #1: Very long-term investment horizon:
Buffett’s obviously very long-term investment horizon naturally leads to his typical selection of traditional, stable companies. The prices of these companies do not grow as rapidly as those of growth stocks. In return, these companies often pay significant dividends, whereas growth stocks pay little or no dividends.
The high proportion of dividend-paying stocks in Buffett’s portfolio is thus more a result of his multi-decade investment horizon and the associated desire for very high, long-term stability. And this exceptional stability is naturally more characteristic of dividend stocks.
However, Buffett values stability over dividends per se, which are merely a typical feature of very stable stocks. Buffett has no issue with growth stocks offering similar or better returns (in this case, through price appreciation rather than dividends) and has no problem realizing profits through stock sales instead of dividend payouts.
Thus, Buffett’s stance cannot be seen as an unequivocal endorsement of dividends.
Buffett #2: Stock trading as a business:
Berkshire Hathaway operates as a business that trades stocks and their dividends. Similar to trading stocks as a corporation in Germany, this creates a tax deferral effect: capital gains from stock sales or dividend income do not have to be immediately taxed, as is typically the case for private investors.
To emulate Buffett, one would also need to trade stocks as a business rather than as a private individual. The ability to make tax-neutral portfolio adjustments is a key component of Buffett’s strategy.
For Buffett, these adjustments also include using dividend income to buy new stocks. These new stocks do not necessarily have to be from the same company that paid the dividend.
If the two criteria—”very long-term investment horizon” and “trading as a business”—are met, then the dividend strategy à la Buffett appears economically sensible.
Comparison: Growth stocks vs. dividend stocks
The following table provides an overview of the fundamental differences and similarities between growth and dividend stocks.
Even among stocks usually categorized as growth stocks, there are some that pay dividends. However, these dividends are comparatively low. Thus, a clear-cut distinction between the two types of stocks does not exist.
It is also possible for a growth stock to evolve into a dividend stock over time by starting to pay significant dividends or substantially increasing existing modest dividends.
The reverse scenario is also conceivable: a company traditionally considered a dividend stock could reduce or eliminate its dividend to reinvest more into the business.
However, the latter scenario is less likely than the former, as investors typically grow accustomed to dividends or primarily buy the stock for its dividends and continue to plan with dividend payments.
| Dividend Stocks | Growth Stocks | |
|---|---|---|
| Total Return (Price growth + Dividend) | Moderate to good | Moderate to excellent |
| Company stability | Mostly very stable | From shaky to stable |
| Withdrawal method | Dividend income, automatic | Partial stock sales, planned or spontaneous |
| “Peace of mind” | High, the cow is not slaughtered | Potentially lower: parts of the cow are sold |
| Time/mental effort | Low. No decisions required (which stock to sell) | Potentially stressful. Selling stocks can be difficult for many investors. Risk of regret later (“I should have sold other stocks; the ones I sold rose sharply after the sale.”) |
Compromise: Start with growth stocks, switch to dividend stocks for retirement
The size of the wealth and age are relevant criteria when deciding for or against dividends.
Those with larger assets tend to prioritize stability over squeezing out the last bit of return. The pressure to grow wealth is no longer as strong.
Older age also generally favors dividend stocks. Shortly before and during retirement, one tends to avoid wild price fluctuations and values regular dividend payments, as one plans to “withdraw” anyway and would otherwise have to sell stocks.
Focusing on dividend stocks from a young age seems unnecessary. Growth stocks should be preferred to achieve higher returns. The associated volatility should be manageable with decades until retirement.
Even middle-aged or older individuals with a low statutory pension and little wealth should temporarily and partially focus on growth stocks.