Welcome to the fourth part of our beginner's guide to investing! By now, you should know why you should invest, how to start and the risks involved. Do check out the previous parts if you haven't already, as it will build up a basic investing foundation for you before reading this part!
In this part, we will be exploring returns in investing. Clearly, we invest because we want to see our money grow. But how does our money grow? What are capital gains and dividends? How do we know what returns we are getting, and what returns should we focus on? Let's find out!
What are returns? Simply put, returns are the amount of money that we get back on our original investment. If we put in $1000, and it grows to $1500, we say that's a 50% return on investment (ROI). Of course, that's an absurdly high rate of return, but it's not impossible! If you had bought Google's shares just 10 years ago, you would have achieved over a 100% rate of return on your original investment!
So, is it really possible to achieve 100% returns? Well, yes and no. The most crucial factor here is time. Over a span of 10 years or more, sure, that amount of return is certainly doable. Difficult, but doable. On average, however, you should expect to get annual returns of around 4-7% on your investments. You may even get negative returns (lose money)!
The main thing to note here is time. The longer your money has to grow, the more returns you're likely to get on your original investment. The concept is simple - any company that you invest in have to take time to grow. Most companies can't go from a small company to a fortune 500 company in the span of a few months.
While it is easy to think that one just has to wait for returns, it might not necessarily be true as well. On the contrary, it is quite easy to invest in a company you think will grow, only to find out that the company has not grown at all even after a long period of time!
Therefore, it is important to do research to find a company you have faith will grow over the next 10 or so years, or even longer.
The tough thing about returns is the long term waiting. Humans are fickle beings, and we generally chase after short term gains. After all, we are not good at imagining things that are years into the future. The toughest part about getting 100%+ returns is the wait.
Can you control yourself not to sell even when the price begins dipping? Are you willing to wait patiently so that you can get a much better return in the far flung future? Here, we encourage you to invest long term and ignore the fluctuations in the short term. Waiting is important to growing your returns, but remember, you should start investing as soon as possible so your money has time to grow.
Let us now look at two main ways that we can get returns on the money that we are investing with. These come in capital growth and dividends.
Capital growth is the raw amount of gains that your money gets as it increases in value over time. In terms of stock, this simply means the growth in share price as compared to the original prices that you've bought it at. The raw difference between the share price you bought at and the share price now is your capital gain/loss.
With real estate, the same thing applies. Capital growth is the appreciation of the value of your real estate investments compared to when you bought them. In fact, capital growth is where the bulk of your returns come from.
As companies grow, their share price increases correspondingly as well. As such, over the years, you will get better and better returns in terms of capital growth as the company grows. Again, time is your friend here.
With capital gains, you will have to sell your investment product before you even see an ounce of return. If you have emergencies, such as a loss of job or whatnot, you might be forced to sell at a loss, severely damaging your returns. Therefore, capital gains are usually called unrealized gains before selling, whereby they become realized gains after they are sold. This is their main caveat.
Dividends, on the other hand, are regular cash payments that occur regularly. They usually come quarterly, but can be different based on the company that you invest in. In terms of real estate, dividends can be thought of as the rent that tenants pay you for leasing the property.
A lot of people like dividends because you don't have to time the market. Just by holding the stock, you will get your returns paid out to you over time without selling the stock. In the end, you can even sell the stock for a capital gain! It does seem like the best of both worlds, but there are some important caveats that we will examine shortly.
People that are less prone to risk prefer dividends over capital gains because it is less risky. You don't have to time the market to sell in order to maximize your profit, reducing a lot of headache in deciding when to sell your stocks. Also, the constant, stable cash flow allows you to gain an extra safety net in terms of liquidity - you know that you will have reliable payments of cash coming in no matter the situation.
Therefore, dividends are generally preferred by those who are less risk tolerant, as they provide a steady source of income without having to sell.
An important thing to note about dividends is that they cannot be seen as a completely reliable source of income, however steady they may be. In the US, there are only less than 70 companies among the millions that increase their dividends steadily year over year.
This means that companies usually do cut their dividends when things go bad. They could reduce the dividend payout, or even use bad financials as an excuse to remove dividends completely, causing you to lose a good source of income. Therefore, before you go all in on dividends, it is important to understand this fact and not rely on it strictly.
Growth vs value, which is better?
There are lot of discussions online about what kind of stocks to buy. Often, these revolves around whether to buy growth or value stocks. Growth stocks are those generally regarded to favor capital gains over paying our dividends, while value stocks are those regarded to favor paying out dividends over gains.
Honestly, in today's society, the line is quite blurred since most growth stocks also pay some form of dividends in order to reduce income taxes. Thus, a third category of stocks have been born - those called the dividend-growth stocks.
What stocks should you focus on getting? There are no solid answers to this question, but let us discuss why you should not focus purely on growth or focus purely on value.
Why not focus on dividends (value)? If a company pays out most of its earnings as dividends, they would not have much money left over to conduct aggressive expansion. This could be R&D into new products, expanding into new market or geographical sectors, or even marketing their existing brands, things that help a company grow their profits.
Without enough money to fund these pursuits, it is almost guaranteed that the company will not grow much. Such companies that focus on paying out dividends will thus see you getting much of your returns through dividends and not much in terms of capital gains.
This could be what you want. Perhaps you are less risk tolerant and want a stable income source. These companies would then be perfect for you as they do not take much risks (to fuel growth) and instead focus on paying our steady dividends. However, since you are giving up on capital gains, you might not be getting as much returns overall as compared to companies with aggressive growth.
Well, what happens if you focus on capital gains instead? The company focuses their profits into investing in R&D and other pursuits, trying to expand their company and find avenues to make more profits. In this way, they are trying to maximize their capital gains.
Such a move generally sees greater returns than pure value companies, since in this competitive landscape, growth is the only way to stay relevant. Any company the stagnates will quickly fade away to be replaced by bolder, newer companies. However, this also correspondingly holds a much greater amount of risk.
In part 2 of this guide, where we examine risk, we talked about diversifying our risks to secure our portfolio. What goes up can come down. With the potential for high growth and high capital gains, we also have a high chance of losing more as well. Even then, we might not be guaranteed a higher return than what we get from dividends, since again, we only see returns when we sell for capital gains. Since capital gains are so highly dependent on when you sell, it can be a headache for investors to determine exactly when they want to take profit.
What about the third kind of stocks, the dividend-growth ones? Well, it does seem like the best of both worlds at first glance. We get some form of dividends, which improves our liquidity and locks in our profits into shorter, more concrete intervals. They also aim for capital gains, since a large bulk of their profits also go into growing the company.
On the surface, yes, they are great. And they are! If you can find them. It can be difficult to spot companies with pristine financials and a good growth plan, all while paying out dividends. Sure, you might say that Microsoft is great, or Apple is great, but what about in 10-20 years? How confident are you in their success?
In truth, it doesn't really matter what kind of stocks you get, but their returns.
It is important to remember that all companies have a set amount of profit that they rake in at the end of each month. Whether companies are paying that out in dividends, or funding their growth, they still have a set amount to work with in the end. And that is important, because the share price usually reflects the worth of the company and thus your returns are based on that too.
What do we mean by this? Let's say company A is valued at $100 per share, and company B is valued at $200 per share. Perhaps company B is making twice the amount of money as company A. If both share prices increase by $100, company A actually has a higher return than company B!
No matter how they both allocate their profits for dividends or growth, the amount of returns you get it dependent on how they make use of their profits, not the absolute size of their profit. This is because share prices are relative to the worth of the company. A company that better makes use of their profits will offer you a higher return than a company that does not.
Therefore, you should simply look at returns instead of focusing on value vs growth and all that jazz. In the end, we are only concerned with how much our money will grow. Instead of worrying about what stocks to get for dividends or growth, look at their returns instead. You can't really go wrong with that.
Factors affecting dividends vs growth
That said, you may have other factors such as liquidity or risk which will determine how you want to allocate your portfolio between capital growth and dividends in order to maintain the liquid cash income that you might need.
As mentioned before, the strong point about dividends is that you do not have to sell your investment products to continue getting them. Without lifting a finger, you are still getting dividends or rent from multiple investment products every month. Isn't that the dream?
Well, yes, a lot of people tend to do that. Since there are liquid amounts of cash coming in quite frequently, dividends can totally serve as a sort of retirement income for you or as a supplementary income. The liquidity provided by this influx allows you to do many things, such as fund your other pursuits or invest in upcoming, more attractive investment products without selling your original shares.
If you suddenly needed money, and all you had were capital gain stocks, you would be forced to sell them without letting them fully appreciate in value. Ideally, you only want to sell your capital gain stocks when you retire to fully reap the potential of their growth.
With dividends however, you don't have to do that, since you never have to sell them. You could just get free money forever. Therefore, those that prefer less risk love dividends.
However, if you are younger, you might prefer capital gains over dividends. This is because capital gains offer a higher potential of growth. While dividend growth is usually fixed and slow (since the increase in dividends is determined by the company), capital gains is solely determined by how quickly a company can grow.
If you are young and can tolerate more risk since you have many years ahead of you, capital gains can be your bet on companies you trust that have very good prospects of the future. Sure it's more risky, but you can earn a lot more with companies that grow rapidly. If you can hold a company that grows all the way until you retire, you could multiply your original investment a lot!
All in all, it is entirely dependent on you to focus on either strategy, or a mix of both. We do recommend mixing both, as it helps you to diversify your portfolio. You will get great gains when the market is bullish (going up) since you have growth companies, and you will buffer your losses a little when the market is bearish (going down) since your dividend stocks are probably still paying you some money.
The nuances of dividends
There are some sneaky things about dividends that you should know about as well that are not so clear cut as capital gains. Capital gains are straight forward - the difference in price is your gain/loss. Dividends on the other hand, are not so simple.
The first thing to note is the ex-dividend date. The ex-dividend date is the date whereby if you buy/sell the stock on that date, the dividend will be paid to the previous owner of the stock. This means if you buy a stock on the ex-dividend date, you won't be getting the dividend for that payout period! Therefore, before you buy, make sure you know when the ex-dividend date is. You can usually find the date in the company's press releases.
Another thing to note about dividends involves basic economic theory. Since dividends are locked in on the ex-dividend date, if you buy on the date, you will not receive that dividend. Therefore, if a company pays out $1 per share, and you buy 100 shares, you technically already loss $100 in returns.
Basic economy theory states that on the ex-dividend date itself, since the share loses a return by the amount of dividend it pays out, the share price will be marked down by the amount of dividends paid out per share. In our above theoretical example, each share that was originally priced at $20 will be worth $19 on the ex-dividend date since the loss in dividends is priced in.
Then, as we approach the next dividend payout, the share price will steadily increase back to pre-dividend levels ($20) again to reflect that return. Note that this does not account for capital gains in the interim, which can increase/decrease the share price as well.
Therefore, it is entirely up to you to buy the share before or after the ex-dividend date. There is no difference, except time. Do you want the current dividend and pay a premium for it, or are you willing to wait a few months for the next one and get it at a discount? It's up to you.
As mentioned before, a key thing to note is also dividend sustainability. Do check the company for its financial health to ensure that it can sustainably pay out dividends based on its profits. This statistic is usually encapsulated in something called the "payout ratio", which is basically a percentage of how much of a company's profits are paid out as dividends. If it's about 1, it could be a danger sign that the dividends might be cut in the future since it is unsustainable to pay out more dividends than the company's earnings.
If you spot a payout ratio that is close to 1 or more, do look to the company's financial statements as well as press releases to see if it is sustainable. Sometimes, the company is simply taking on debt to leap onto a good opportunity, and the reduction in its profits is just temporary for greater long term returns.
Hopefully by now, you have understood some of the nuances of returns, and why you shouldn't be too focused on either dividend or growth, but instead spread out your assets between the two. Remember, diversifying risk is a key strategy here, as no one wants to be caught out losing everything in a wrong bet.
You should be semi-ready by now to take your first steps into the investment world. We have barely scratched the surface of the types of products and strategies, but as an investor, these are things that you should slowly explore yourself and learn.
Only you can help yourself along this journey since it's your money that you are trying to grow. No one can tell you what to buy or sell. Take advice, but don't blindly follow. Only you should make that final decision on your own.
At this point, we have given you a basic understanding of why you should be investing, how to start investing, the risks of investing, the types of investment products as well as a basic introduction of returns in investing.
Read on for part 5 of the beginner's guide to investing, where we will look at investing strategies which you can consider using while investing.
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