What are the Tradeoffs Between Dividends & Growth?
The decision to pay investor dividends involves a trade-off for company management and investors. If companies choose to pay dividends, they distribute all or a portion of earnings directly to investors. This limits the amount of investment the companies can make toward future growth. From an investor's perspective, advantages and disadvantages exist when investing in either companies that pay dividends or companies that invest in future growth.
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Performance Trade Off
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Most dividend-paying companies are large, well-established firms that have already experienced a significant amount of growth. Many small and mid-sized companies, meanwhile, choose to reinvest their earnings instead of distributing earnings directly to investors. Historically, small and mid-sized companies have outperformed larger companies in terms of investor returns. Since 1925, large dividend-paying companies have earned investors an average of just over 10 percent per year, according to a study performed by Duke University. During this same time, aggressive growth companies earned investors an average of over 16 percent per year.
Risk Trade Off
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When a company chooses to distribute its earnings directly to investors as cash dividends, it removes some of your risk as an investor because you receive money that cannot be lost. When a growth company reinvests earnings, there is always a risk that its investments will not pay off, which means the price of the stock you own can decline or underperform other stocks.
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Tax Now or Later
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Investing in companies that pay dividends versus companies that reinvest for growth involves a trade-off between paying taxes now and paying them later. When you earn dividends, you have to report them on your annual tax returns. Capital gains, however, are only assessed when you sell the stock. Thus, if you own a growth stock that does not pay dividends, you can hold it for many years before paying taxes on your investment gains.
Income Versus Growth Potential
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Investors who are retired or nearing retirement age are more likely to be interested in earning an income from their investments than they are future growth. When you invest in a company that pays regular dividends, it offers you a steady income. However, this income can come at the expense of future growth potential. Thus, if you have many years before you retire, it may be better for you to invest in companies that reinvest their earnings for future growth.
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References
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