When purchasing stocks for your portfolio, one of the most important attributes to take into consideration is whether the asset is a dividend stock or a growth stock.Â Not only can the decision be important in regards to the amount of money you make on your investment, but it is usually best made while considering the goals of your portfolio.Â Each individualâs financial goals are important and knowing how and why to differentiate between these two classes of stock is an important step in making sure that your investments are serving you well.
Stocks are all fundamentally the same.Â Each share that you purchase for your portfolio represents just that: a share of the companyâs profits.Â Because you own part of the company, through your purchase you are entitled to a portion of any profits earned.Â However, different companies pursue different methods of paying those profits out to their shareholders.Â The two basic methods of distributing profits are dividends and growth through reinvestment.
How and Why Dividends are Paid
The payment of dividends is the oldest and one of the easiest understood methods that companies use to distribute profits to their owners.Â If a company makes a profit or has some other income such as a patent sale or lawsuit winnings it can choose to simply âgiftâ all or some of the proceeds to its shareholders.Â Dividends can also be paid when a company has more cash on hand than it knows what to do with.Â
Normally dividends are paid quarterly, although some companies pay at other intervals.Â Occasionally, a company will declare a âspecial dividendâ which is a one-time payment in addition to any other regular dividends. Â These special dividends usually occur when companies need to get rid of cash that they have accumulated and which they can see no other profitable use for.
When you receive your dividend check it is usually in the form of cash.Â Most of the time your brokerage will give you the option of re-investing your dividends in the same company.Â This is usually a good idea because if the company you own shares in has been successful enough to send the owners a check, itâs usually a safe bet that they will continue to be successful in the future.Â Reinvestment of dividend checks also allows your holdings in the company to enjoy the exponential benefits of compound growth.
Why Growth Stocks Grow
The other method that companies have to pay out profits to shareholders is through growth.Â Instead of sending any excess profits or other cash to the owners, a company can decide to reinvest that money in the business.Â These investments could be new printing presses for a newspaper company, new cell towers for a phone company, or anything else that might help a particular organization to gain or keep an advantage of over its competition.Â This is an excellent option for smaller companies that are still growing because it allows them to pump all of their earnings into growth without worrying about sending their profits to the stockholders.
Now this may seem as if the owners of growth companies are getting the short end of the stick, but thatâs not the case.Â Whenever a company decides to invest in its growth it is effectively increasing the value of each outstanding share of stock.Â By investing in future profits, each share becomes worth more in the future.Â Because there are no dividend checks going out, this method of distributing profits to shareholders can exhibit a more constant growth than the reinvestment of quarterly dividend checks.
Is there Crossover?
Fortunately for the investor, there is no absolute need to choose between these two types of stocks.Â This is because the stocks of many companies offer a combination of the two forms of payment.Â Many companies, especially large American blue-chips, offer a small to medium dividend but also keep some of their profits to fund growth.Â This allows the investor to have a more balanced approach to earnings distributions for their portfolio.
What about Penny Stocks?
Penny stocks, usually considered those with values of less than five dollars per share, can offer the combination option, but most of the time they are an either-or situation for the investor.Â Penny stocks usually signify one of two things about the company they represent.Â
If the stock does not pay a dividend, then it is most likely a small company looking to grow and therefore is spending every dime it can get its hands on in order to fund that growth.Â This can be great for the investor because it might mean explosive future growth if the company has a good business model and management team.Â On the other hand, many start-ups and small companies go bankrupt in a short amount of time.Â This means that an investor in a penny growth stock usually has a greater potential to lose everything.
If a penny stock does provide a decent dividend yield it usually means one of two things.Â The first is that its share price may have dropped from a higher point where such a yield did was not such a bargain.Â In that case, the investor must carefully consider the reasons behind the drop in price and whether or not a company can survive whatever troubles it is facing.Â
The other thing a decent dividend yield in a penny stock can indicate is that a company has recently issued more shares into the market.Â This increases the supply of shares which can drive down the price.Â Companies usually do this to raise capital for expansion or investments in research.Â If the company you are considering is in this situation it could prove an excellent combination of dividend and growth stock in the future.Â Just beware that if the expansion or research doesnât go as planned then future dividends may have to be cut in order to keep the company afloat.
Picking the Right Stocks for Your Portfolio
In the end, the choice of stocks for your portfolio is always a personal decision.Â There are a few general rules of thumb that you can follow, however.Â If you plan on using your portfolio to produce income streams in the present or immediate future, dividend paying stocks can be the way to go.Â Simply inform your brokerage that instead of having your dividends reinvested you wish to receive them as cash.Â This ensures that you donât have to sell shares in order to receive the profits from the businesses that you own.
On the other hand, growth stocks lend themselves well to portfolios that you do not intend to tap into in the next five years or longer.Â Growth stocks tend to be more volatile but they also tend to be smaller, growing companies that havenât matured into large dividend paying corporations yet.Â This makes them a great option for retirement portfolios or college savings plans for younger children.Â Since you wonât be withdrawing from your holdings for a few years, these companies will have the time that they need to grow and you wonât be relying on the profits from them for your day to day needs.
Ultimately, the stocks you choose are up to you.Â Be sure to research them well and itâs always a good idea to speak with your financial professional before making any large moves in order to understand the risks and rewards of your potential investment.Â Good luck with your picks, and happy investing.