You have heard and read about it – the exciting ways to make money from the stock market. You have seen people made a fortune, drive big cars, buy luxury houses all thanks to the wonders of the stock market. You are all pumped up, all excited but then a big question arises – How? Well there are generally 2 primary ways or focus people generate wealth from the stock market – dividends or capital gain. Although some investors choose to make money from both but in the initial stage, they would need to focus on one. So which is better to focus on? Dividends on Growth? Lets take a look at the pros and cons of focusing on either one.
What Are Dividends?
Dividends are cash rewards that the management of the company award to all their shareholders. This is normally done once, twice or 4 times a year.
How To Generate Wealth with Dividends?
The ideal way to generate wealth with dividends is through the idea of compounding. Compounding means the ability to generate more returns on the returns you generated from an investment. It is also known as generating interest on interest. So imagine if you invested $1000 on a stock and it paid you dividends of 5% or $50 and instead of spending that dividend, you decided to use it to purchase more stocks. Then your total investment will now be $1050 and if the stock pays another 5% dividends next year, then your dividend next year would be $52.50! That is by just buying more stocks with the dividends they gave you. Imagine if you repeated this process over and over again, the amount of dividends would be increasing exponentially.
Pros of Using Dividends
1. The benefit of focusing on dividends to build your wealth is that it is one of the most stable methods to do it. You will be eliminating the one key question that has been plaguing most investors today – when do I sell my shares? Because if you have found a stock which has constantly been paying you good dividends, you will never ever want to sell it away!
2. Its also easier to determine the entry price. Valuing a dividend company is extremely easy. You simply need to pay attention to the dividend yield of the company. The formula of dividend yield are as follows:
For example, if you see that the price you pay for the share today will give you a dividend yield of 5%, you simply need to compare that figure with any low risk investments that you have today such as fixed deposits. If the dividend paying stock can give you a way better return than your low risk investment then the stock is a very attractive buy at that price.
3. You will also have stronger emotional stability. This is one key weakness of most investors that has cost them a lot of money. If you invest in dividend paying stocks, you will be more confident to buy more stocks if their capability to pay dividends are in tact.
Cons of Using Dividends
1. It can be very slow. If you observed the previous diagram, you will see that Warren Buffett made majority of his wealth after the age of 60. This is because it takes time for him to get the dividends, and find a dividend stock selling at an attractive price to invest in. Most investors would not be too happy if they have to wait for a very long time to enjoy the fruits of their efforts. Therefore it requires a lot of patience from the investors.
2. Next is that the company may not last the test of time. Before reaching the point where the dividends are enough to fund your lifestyle, the company’s competitive position may be eroded by new disruptive technologies or businesses.
What are capital gains?
Capital gains, as most of you would know would be the profit you gain when share prices goes up. It is the most common and desirable way for an investor to generate their wealth from the stock market. Capital gains can be achieved when the business you invested in becomes more valuable in the future.
Pros of Capital Gains
1. Wealth is generated very quickly. Dividends paid by the company are normally quite predictable and the highest that I have seen so far is a dividend yield of 10%. Therefore, your return for the year is pretty much capped. But for share prices, how much could it possibly go up within 1 year? Virtually unlimited. I have seen stocks that goes up by more than 100% in a single year. Therefore, you can now see why this a preferred way to generate income from the stock market.
2. It makes investing more exciting. Lets face it, you will get very excited when you see your share prices going up. In fact, it will also motivate you to stay in the game of investing.
Cons of Capital Gains
1. It is very hard to find such a company. Share price being completely unpredictable means that it is also very hard for us to determine which stock will give such high returns in the future. Compared to investing for dividends, you would be checking the dividend tract record of the company and if they have a long track record of rewarding dividends, it helps you to build your confidence. Therefore, if you decided to invest in companies for capital gains, the confidence that you have invested in the right stock will not be as strong as that with dividend stocks due to uncertainty.
2. When do you sell becomes a problem. The issue plaguing most investors face is the dilemma of selling their shares – if they sold too early, they will miss out on more capital gains but if they sold too late they will make lesser profit when share price goes down. On top of that, they do not have constant dividend streams to assure them to hold onto the stocks over the long term.
In a nutshell, if you are just starting out and with a smaller portfolio, it is often wiser to focus on capital gains as the main way to generate wealth from the stock market. Once your capital size gets bigger, you may slowly refocus your portfolio back to dividend paying stocks. Although this may the conventional wisdom, but it may not necessarily apply to everyone. Some may even choose to focus on both at the same time. However, whichever investing philosophy an investor take depends on their preference whether their stock picking capabilities, lifestyle or time.
Disclaimer: All facts and opinions presented are for educational purposes only. This is not a recommendation to buy or to sell. The author involved in the writing of this message has no vested interest in the companies. Please consult a professional for expert financial or other assistance or legal advice.