Dividend shares or growth shares? Or both? Deciding how you invest your hard-earned money can often start with this simple question.
There are a number of factors to consider, including whether you need an income from your shares, and what your investing time horizon is. Many people may be happy to dabble in both dividend and growth shares by investing half of their portfolio in high yielding shares and the other half in growth shares with no dividends. But is that the best solution, or should your portfolio be skewed one way or the other?
To help you decide how to structure your portfolio, we take a closer look at the pros and cons of dividend shares and growth shares below.
Dividend shares versus growth shares
If you need to live off your portfolio (say, as a retiree), or use it to supplement your current income, then you'll want to invest at least the majority of your portfolio into high-yield dividend shares.
Shares such as Rural Funds Group (ASX: RFF), Macquarie Group Ltd (ASX: MQG) and Telstra Corporation Ltd (ASX: TLS) are all great candidates for a dividend-focused portfolio, in my view.
However, if you don't require any additional income, I think there is an argument to be made for growth shares. Shares such as Altium Limited (ASX: ALU), Afterpay Ltd (ASX: APT) and Nearmap Ltd (ASX: NEA) all fit this bill.
The best way for me to demonstrate why is via a little bit of maths. If you're not so keen on formulas, you can skip right to the results!
The math
Let's assume a starting investment of $10,000, with an average return of 10% each year and a marginal tax rate of 32.5% (which is the rate for a taxable income of $37,001–90,000).
Using these figures, we will work out the total return difference between a dividend and growth-focused investor over 10 years.
Dividend investor
To keep things simple, we will assume the total return from the dividend shares to come from the dividend itself; that is, we assume the 10% return to come in the form of an annual dividend.
- Formula: Investment[1 + r(1 – T)]^10 = 10,000[1 + 0.1(1-0.325)]^10
- Post-tax return: $19,217
Using the appropriate formula we get an end result of $19,217. Now that's nearly double your initial investment, and assumes the dividend each year is reinvested at the same 10% rate.
However, what hurts this return is paying tax each year on the return prior to letting it compound. So let's look at the growth scenario for comparison.
Growth investor
Again, keeping things simple, we will assume the company pays no dividend, and all returns come in the form of capital gains. Additionally, for a share holding period of greater than 12 months the owner only needs to pay capital gains tax on half of the gain. This makes the formula a little more tricky but if you're not interested in the maths, remember just look at the results.
- Formula: Investment(1 + r)^10
- Pre-tax return: $25,937
Now, since we only pay tax on half of the capital gains:
- Formula: $25,937 – [0.5 x (25,937 – 10,000) x 0.325]
- Post-tax return: $23,347
The growth investor walks away with a post-tax return of $23,347 on their initial investment, which is nearly 22% more than the dividend investor.
Foolish takeaway
As you can see, there is a decent difference between the two approaches over the 10-year time horizon, and this gap only increases when you increase the holding period. This is mostly thanks to the pre-tax compounding effect of the growth shares. Essentially, with growth shares you only need to pay tax after you have sold them, therefore the asset's compounded rate of return is higher.
However, because many companies pay a dividend and retain a significant chunk of earnings for reinvestment, you can hope for capital and dividend returns.
That being said, if you have a long time horizon and limited need for the dividend income, I believe it can pay to skew your portfolio to growth shares.
