Two ways to make money in the stock market-Capital Appreciation and Dividends

By Dave Van Knapp

In stock investing, there are two—and only two—ways  to make money:

  • Capital appreciation
  • Dividends

 

Indeed, the equation for total performance is Total Returns = Capital Gains (or
Losses) + Dividends Received. Notice that the dividends are always positive,
while capital gains can in reality be capital losses.

I have come to believe that these two goals are very different and that each
requires its own strategy. In seeking to achieve each strategy, one should use
techniques and tactics that are distinct and tailored to that goal and strategy.

In a nutshell, investing for capital appreciation is “buy low, sell high.” It is
what most investors think of first when they think about stock investing. It is
what the news reports on “How the markets did today” are all about. When
they tell you whether the Dow went up or down, they are talking about stock
prices only. Dividends are ignored.

Investing for dividends, on the other hand, is about the accumulation of wealth
by collecting dividends from stocks that kick out healthy, reliable, and growing
cash streams to their shareholders. The dividends can be re-invested to
accelerate the wealth accumulation process, or they can be cashed out
immediately and used as current income. A particular sub-category of dividend investing is dividend-growth investing, which places great emphasis on purchasing companies that increase their dividends every year. Some companies have streaks of increases that are decades long.

It is always a good idea to be clear about what your goals are in investing in
stocks. I advocate writing out your goals and strategies. There is nothing wrong
with shooting for both goals. I do that myself, in separate portfolios. I encourage you to segregate your portfolios for the two fundamental goals—capital appreciation and dividends—and to develop separate strategy or policy statements for each of them.

There are many commonalities across both goals, of course. Selecting excellent
companies, buying them at advantageous prices, and managing your
portfolio effectively are best practices that apply to either strategy.

But there are important differences:

  • The types of stocks one buys for capital appreciation or for dividends may
    have very different characteristics. For example, so-called “growth” stocks
    or ETFs will predominate in a portfolio aimed at capital gains. On the
    other hand,  the dividend yield is hugely important in considering stocks
    for a dividend portfolio, while that may be irrelevant in a “growth” stock.

 

  • The ways one controls risk after purchase will probably be different. In a
    capital gains strategy, stop-loss orders can be an important way to protect
    profits and curtail losing positions. In a dividend portfolio, on the other
    hand, stop-loss orders may not be used at all, as the idea is to keep the stock as long as its dividend is reliable and growing.

 

  • It’s always a good idea in investing to “keep your eye on the ball.” But the
    ball is different in the two strategies. In capital-gains investing, the ball is
    growth through price increases. In dividend investing, the ball is ever-
    increasing dividend streams
    .

It probably would be going too far to say that the dividend investor stops caring
about the prices of his or her stocks, but those prices truly take on less
importance. The fact is, the truly committed dividend investor measures the
value of his or her portfolio by its ability to spin out ever-increasing cash
streams. That becomes way more important than how much money one could
receive if the portfolio were liquidated. As a result, the dividend investor often
welcomes price dips: It provides the opportunity to gather more shares for the
same amount of money, which leads directly to a jump in the dividend stream
because of the larger number of shares owned.


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