What is the primary goal of investing? Posed to group of people you’ll probably receive a variety of answers like:
- “Make lots of money”
- “Retirement”
- “Financial freedom”
- “Buy a Porsche”
But when you really get to the root of these responses what most people are saying is they invest because they want a stream of income to pay for their needs and wants. At its core, investing is about planting seeds today that have the potential to multiply over time.
Though there are countless options available to the enterprising investor, in this post I’m going to focus on individual stocks.
Contrary to what most people think about stocks, they’re not just 3-letter gambling chips to be used for getting rich. At their core, stocks represents an ownership stake in the underlying business. Granted it’s a small stake but once you buy a single share, you’re now a partial owner of the business. That’s pretty awesome when you think about it. You didn’t have to come up with the idea or startup capital. You don’t have to deal with the day to day operations. Yet by establishing a stock position, you’ve put yourself in line to benefit (or suffer) from the financial results of the company.
At their core, stocks represents an ownership stake in the underlying business.
More Than One Way to Play
To me, stock investors fall into 2 broad categories; capital appreciation investors and dividend growth investors. The holy grail is when you can be both at the same time. Let’s dig a bit more into this.
Capital Appreciation Investing
Investors in this category are focused on “buy low, sell high”. Their goal is to buy ownership in a company at a price below what they feel is the true value and wait for the price to move. If that happens they sell and take their gain. For example, when the price of Facebook’s (FB) stock dropped in response to the Cambridge Analytica leak, a capital appreciation investor might have taken this opportunity to load up on shares and wait for the price of the stock to recover. Once it did, they’d sell it for a profit.
Fun Fact: Facebook’s stock price reached a low of $152.22 in response to the breach. As I write this, the stock has recovered to $209.36. Were you to sell, you’d realize a gain of almost $60 per share. Not bad.
While this seems pretty awesome we should also consider the downsides to this approach. Because you bought Facebook in March and sold it in July, the gain is going to be taxed at ordinary income rates. Depending on your income bracket and where in the country you live, this can equate to paying 25% – 45% of your gain in taxes. Not so fun. In order to pay the lower long-term capital gains rate of 0%, 15%, or 20%, the investor has to hold the security for at least 1 year.
Because capital appreciation investors regularly buy and sell their positions, they’re constantly in the hunt for the next investment. A big challenge with this approach is depending on market conditions, it’s not always easy to find a great company selling at a discount. This could mean extended periods of time where the investor is not in the market. Because the primary way a capital appreciation investor seeks to make money is a rising stock price, a substantial drop diminishes the effectiveness of this strategy.
In order to pay the lower long-term capital gains rate of 0%, 15%, or 20%, the investor has to hold the security for at least 1 year.
Dividend Growth Investing
Where the capital appreciation investor primarily uses arbitrage to generate income, a dividend growth investor has no real inclination to sell. Dividend growth investors buy ownership in companies that regularly return capital to the investor in the form of dividend payments. Dividends are typically paid either on a quarterly (every 3 months) or on an annual basis. What this means is the dividend income investor doesn’t have sell their position to receive income. They’re paid simply for continuing to hold the stock. The amount paid varies but is most often 2.5% – 7% of the current stock price. This percentage is referred to as the dividend yield.
For example, AT&T (T) currently pays an annual dividend of $2.00 per share. As I write this, the current stock price is $31.71 per share. 2.00 / 31.71 equates to a yield of 6.31%. The dividend investor has the choice of taking the cash or requesting that the dividend be reinvested to buy additional shares of the same stock. This is a great example of money making money. Dividend reinvestment allows the investor to automatically increase their ownership stake in the underlying business without an additional outlay of capital.
Similar to the capital appreciation investor, those taking a dividend growth approach aim to purchase stock positions at a discount. A drop in stock price isn’t necessarily a bad thing for the dividend growth investor. It allows them to acquire more shares at a lower price and higher dividend yield. Continuing to reinvest income if the stock price drops also allows the investor to acquire additional shares at a more attractive price.
For an excellent read on the topic of dividend growth investing, check out the book Get Rich with Dividends by Marc Lichtenfeld.
Comparing the Approaches
In my mind one of the biggest differences between the two approaches is how long the investor typically holds their position. The disciplined capital appreciation investor picks their stop-loss and sell targets before entering the position. If the price of the stock appreciates to their sell target, they get out of the position. It could be weeks, months or years before this happens. Regardless of the time period, the capital appreciation investor does not realize any income until they sell. Depending on how long it takes the stock to reach the price target, there could also be unfavorable tax consequences.
The dividend growth investor initiates their position largely based on track record of the underlying business. They’re looking for 2 factors as far as track record; regular dividend payments and a regular increase in the dividend. Disciplined investors also consider business financials and the competitive position in the market as an additional factor in making their purchase decision. As long as both remain favorable, the time to sell is almost never.
Dividend growth investing allows the investor to create a goose that keeps laying eggs without having to kill the goose. As long as the stock has been held for 60 days or longer, the dividend payments become “qualified” meaning they are taxed at the long-term capital gains rate of 0%, 15%, or 20%. Which those rates the dividend growth investor pays is based on their annual income.
Tying It All Together
I hope this post has provided you with a very basic understanding of both investment strategies. They’re both great ways to grow a portfolio. Each has its respective advantages and disadvantages.
The capital appreciation investor gets their money back faster but may pay higher taxes. They are also constantly in the hunt for the next opportunity. The dividend growth investor takes a buy and hold approach in hope of receiving income over an extended period of time. The downside to this approach is there’s no guarantee that just because a company has paid and regularly raised the dividend they’ll continue doing so.
There are many great books written on this subject. If you’d like to hear my thoughts on some good ones, please check out my Book Reviews section. My favorite books on investing are under the “Essential Reading” drop down at the top of this page.
I’d love to hear from you. Leave a comment below with your thoughts. Which approach is better in your opinion and why?
A great FREE tool I personally use for tracking my portfolio is Personal Capital. When you click this link to sign up for your free account, both you and I will receive $20. Every little bit helps right?
Full Disclosure: The links on both the Essential Reading and my Books Reviews pages contain my Amazon affiliate code. If you purchase a book using that link I get a few pennies. Doing so does not change the price of the book for you. In addition, at the time of writing this post, I own a position in AT&T (T).
Legal Disclaimer: The information provided and accompanying material is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney, CPA or other professional to determine what may be best for your individual needs.