In recent times we have seen record retail participation in stock markets around the world. On surface, building wealth through stock investment can appear and even sound easy. The trouble is human greed, unrealistic expectations, and impatience can often lead to overtrading and terrible underperformance very quickly.
By investing prudently, the stock market is actually a very accessible avenue to build long-term wealth and achieve financial independence over time. Anyone can harness the potential of the stock market if they invest with a steady hand and stay disciplined consistently.
However, as with most things in life, achieving the potential rewards is actually much harder than it seems to be. If it is so easy, everyone will be walking around rich through their investments. Not everyone can be successful at the same time partly because stock investing or trading is a zero sum game. Think about it, if one investor wins, someone else is losing. The wealth is gained and flowed from another investor. No money or value was created in the exchange. In fact both seller and buyer lose a little to the middlemen – brokerage, fees and taxes.
I used to overestimate my ability to profit lucrative returns from investing in the stock market. I mean how hard could it be? Just pick a few companies that is promising and showing the potential to grow consistently each quarter. My focus was on high-growth companies, which naturally would not pay out dividends but reinvest all earnings to grow the business instead. I was more interested in making money from instant mega stock price appreciations (read as greed and impatience), instead of accumulating dividends over the longer term.
Who doesn’t want instant gratification? The ability to make quick bucks easily. Everyone wishes for that, until we found out that the market can be gut-wrenchingly volatile. The expectation of big rewards comes with big risks. There are many ways we can make mistakes when our focus is bias towards high-growth companies for quick gains.
When the market is climbing, people get excited. Greed steps in and money starts to pile into stocks, especially those of high-growth companies. By the time a down-the-street retail investors like you and I join the party, vast majority of the gains have already been made. When the inevitable but healthy correction steps in, we panic and end up cutting loses or selling at lower prices eventually. I am not proud to say that I have made these costly mistakes, a few times.
There is nothing wrong to focus on high-growth companies and it can certainly be very rewarding. I have both made a lot of money and lost as much over the years of investing. It boils down to your time horizon, risk appetite and the ability to follow and understand the development surrounding the stocks you are invested in.
Since I have a day job and stock investing is what I do in my free time, perhaps investing in ‘boring’ dividend-growth stocks is the way for me to achieve better returns compared to monies placed in fixed deposits or unit trusts. My new approach is to accumulate stocks of good businesses from a diversified range of industry. They may grow at a slower pace and does not promise juicy capital appreciation, but at least they are steady in consistently paying dividends to shareholders.
Why dividend-growth companies?
The following are four reasons why we could consider investing in dividend paying companies over the long term. As always, I have borrowed insights from others and in no way claim the information shared is of mine alone. To keep the article simple and short, I have not included details of studies used.
1 – Dividend-growth Stocks Can Outperformed the Stock Market
It is interesting to note that historically, stocks of companies that consistently pay dividends have outperformed non-dividend growth stocks. Strong dividend-based stocks also tend to hold their grounds better during times of volatility.
Why is this so when theoretically high growth companies are reinvesting all their earnings and cash back into their businesses? The answer lies in the challenges of increasing the earnings continuously.
Growth oriented companies can run into a point of market saturation sooner than expected. On the macro side, there can also be major shifts in technology, consumer preference or change of competitive landscape that can disrupt the company growth.
When an unfavourable condition occurs, an already very richly valued stock can result in very poor shareholder returns. A high-growth aspiring business can struggle to find more profitable growth opportunities to keep the earnings rising. It may have to look broader to find more opportunities and this can sometimes take them away from their area of expertise. Diversification can be a good thing but it also poses risks because it can result in management making poor capital allocation decisions such as overpaying for acquisitions.
Of course companies that pay out dividend consistently are not immune to these risks. But these companies tend to have long-term focused and conservative management that are prudent on the company’s balance sheet and growth investments. If you are already paying out 50% or more of profits each year, you will be far more selective with what acquisitions or investments you make. A commitment to paying dividends places more discipline on management teams to invest in their highest-returning, if not, most promising projects.
2 – Dividends can be a big chunk of long-term market returns
When it comes to investing in the stock market, profiting from stock price appreciation is usually the first thing that comes to mind. This is usually more achievable when you invest in high-growth stocks that do not pay out dividends. If this is your goal, then the only way you can earn a return is through share price appreciation.
Investing in a high-growth stock can be very rewarding, only if you have selected the right company, buy in at the right time and are able to hold on to it to your advantage. For example, let just say you have bought Alphabet Inc. (GOOG), a tech growth stock which pays no dividend all these years.
In general the share price has been appreciating as the company grows throughout. But if you had had to sell it to meet certain financial obligation during the lows of the financial markets such as the 2008 subprime crisis or 2020 Covid-19 pandemic, then most, if not all, of your capital gains may have vanished.
In a financial crisis, it is not uncommon to end up losing years of accumulated unrealized profit in a few weeks if the market tanks. It is brutal but you can very much ended up with nothing for all your patience staying invested all these years.
On the other hand, a quality dividend-growth stock would have provided you with rising income in the form of dividends, which you can either reinvest into more shares or save into other financial instruments. Basically you will be able to compound your investment income or at the very least enjoy spending the dividend income to improve your quality of life. The dividends that you received are tangible and provides benefits that no market crash can undo.
Therefore in a period when stock prices stagnate or decline, dividends from stocks can actually account for a significant portion of your stock market returns. And if you reinvest the dividends into more quality dividend-growth stocks consistently over time, then market corrections can provide you with opportunities to buy these stocks at much lower price, which in turn sets you up for higher yield.
3 – Focusing on dividend stocks can help you avoid costly mistakes
Throughout the years I have my fair share of putting hopes on high-growth stocks that seems promising with potential strong earnings growth. Most of the time the growth turns out to be unsustainable and the stock price fizzles down.
Although few and far between, there are also always a few companies that seem to be delivering increasing earnings consistently each quarters. The stock prices of these companies continue to rise strongly making you green in envy for not being on the boat. Of course it always seem easy on hindsight, so we beat ourselves for not taken position and stay invested in these proven high-growth companies.
Not wanting to pay more than it should be, I have also made mistakes sitting on cash in anticipation of the next market correction, hoping to pick up these runaway high-growth stocks at a bargain. This has many times turned out to be a costly game as the stock price continue to soar.
You can see how human nature can be a part of making market timing the biggest danger to achieving your long-term investment goals.
Investing in dividend-growth stocks can help you avoid these pitfalls because your focus will be centred on putting money in long term quality and proven businesses. Being a dividend-growth investor can potentially change your mind-set from being a short-term trader or speculator to a true long-term investor. This way, dividend-growth stocks can help you avoid the meaningless and potentially harmful day-to-day fluctuation of stock prices.
When you are invested in long term dividend picks, you can stop worrying about buying stocks at close record highs or missing out of spectacular gains by sitting on the side-lines. All you need to do is to maintain a long term, value-oriented contrarian mind-set that will help you to invest consistently to benefit from steady returns over time.
4 – Dividend-growth stocks are ideal for retirement savings
Dividend-growth stock investing can be an ideal vehicle to help you achieve a good standard of retirement living. Bond yields have remain low and fixed-deposit interests are close to non-existence in many developed countries. In comparison, high dividend stocks can offer significantly better returns which will not only help you grow your income, but protect the purchasing power of your money.
Dividend stocks also have retirement appeal because they have exhibited lower volatility over time. When it is time for you to retire, you would want to stay away from those high-risk-high-return kind of investment. Stability and certainty of income is now more important as you no longer have the luxury of extended time horizon to iron out market booms and busts.
When it comes to investing for retirement, hopefully we are more objective and prudent in our investment decisions. You will start to think of your stock portfolio as a business, with long term emphasis to maximise cash flow and value. This is where dividend-growth stocks comes into play. They are generally more defensive, matching retirement planning requirements.
Owning dividend growth stocks helps to separate long-term total returns from the fluctuations of the stock market. Instead of worrying about your portfolio’s price performance at any given day or year, all you need to do is to keep an eye on the dividends rolling in. As long as you receive your dividends to fund your retirement lifestyle, you can remain calm, stay invested and let your capital continue to work. What matters most in the long-term is cash flow.
One size does not fit all
Despite the reasons above, I am by no means saying that investing in dividend-growth stocks is the best way to go. It is certainly not the fastest way for you to achieve super profit from the stock market. Again it very much depends on your time horizon, risk appetite and your ability to understand and evaluate the potential of each opportunity.
You will have to consider your circumstances and decide what’s best for you. My focus now is to put more emphasis on stable dividend-growth stocks instead of gunning for the next high potential but risky growth stocks. Slow but steady is the more prudent way when it comes to life-long investing.
To succeed in the stock market, we have to be patient and work with the power of compounding because this is how money can be put to work at all times for as long as possible. It is with this that I believe that dividend-growth stock investment can be a good vehicle for regular people to achieve sufficient wealth that leads to financial independence over time.