Monday, March 30, 2015

Comparing your results to S&P 500 could be dangerous for dividend investors

As a dividend growth investor, I tend to create diversified portfolios full of companies that regularly raise dividends. I try not to overpay for shares in these companies, when I put my money to work. Dividends are more stable than capital gains, which is what makes them ideal for those who want to live off their nest eggs. The end goal for me is to generate as much in dividends to pay for my regular expenses every month. I expect the forward dividend income generated in my taxable accounts to reach the dividend crossover point at some point around 2018. The stable nature of dividend income makes it easier provides much more confidence in projecting future dividend income at a certain point. On the other hand, I cannot tell you whether the value of the portfolio will be twice as much as today's or half as much.

However, I regularly receive some feedback from new readers, because they might have overheard about the importance of benchmarking against a common benchmark, such as the S&P 500. While I have tracked results versus S&P 500, I think that this is not a value added activity for my strategy and my goals. I believe that tracking my total return performance relative to S&P 500 is not going to add any actionable insights, that would help to me achieving my goals. My goals including reaching a certain target annual dividend income within a certain time period. Whether I do better or worse relative to some random benchmark is irrelevant to my long term goals and objectives.

I monitor the annual operating performance of the businesses I have invested in, as I review them at least once every 12 - 18 months. I also review press releases regarding quarterly results, dividend increases announcements, mergers and acquisitions. I track the organic dividend growth rate for my portfolio. I also track dividend income received, and try to understand whether growth came from organic dividend growth, dividend reinvestment and new cash contributions. As you can see, it doesn't matter for my goals and objectives, if over the next 5 - 10 - 15- 20 years the total return on my portfolio is better or worse than the S&P 500. Not only is relative performance versus a benchmark lacking actionable insights for me, but it could be downright dangerous for dividend investors like me.

The biggest danger in comparing my performance to that of the index, is reaching dangerous conclusions. For example, stock prices do not go up or down in a straight fashion. They move depending on a variety of factors, that few can predict in advance. Sometimes, even quality companies might be under appreciated by market participants, and their stock prices might stagnate for extended periods of time. At the same time stock prices can be increasing, as evidenced by stock indexes. However, if the fundamentals of the underlying businesses are doing well and improving, then holding on to those businesses might still make sense. This is because while their price is doing worse relative to the stock market index, they are getting more valuable, despite being underappreciated by the stock market. It might take the quoted price some time before investors realize this discrepancy and bid up the price. If I sold undervalued shares, to buy something that has done well in price, I would be selling low and buying high. I believe that this is not smart investment behavior. Please remember that the stock market is there to serve you, not to instruct you. The time to sell a business is when it no longer performs to expectations, not because the stock prices a group of other businesses have done better in the past 3 - 6 months.

For example, back in 1999 - 2000, many shares of tobacco companies, financials, utilities and REITs were punished by investors who wanted new economy technology companies. The popular indexes such as S&P 500 and Dow Jones Industrial's Average added technology companies in 1999 - 2000. The performance of those companies was great for a while, as everyone gobbled up those shares in speculative frenzy. The old economy boring companies were not viewed as attractive enough. If a dividend investor had sold their tried and true investments because they underperformed for a short period of time, they would have made a terrible mistake.

If I am impatient however, I would feel like I am missing out by comparing my “slow moving” stocks to the index and chances are I would sell as a result of the exercise. This is usually at the same time that the index would likely start dragging its feet, while the shares of the former “slow mover” finally get appreciation by buyers. I see this happen again and again. This is why most individual investors never make any money in stocks – they go from one strategy to the next, chasing hot strategies and looking for something that magically works all the time. If they stick to a slow and steady strategy like dividend growth investing, they would do very well for themselves over time. This is because rising earnings per share, leads to rising dividends per share, which ultimately makes stock prices more valuable. Plus, the fact that most dividend investors are truly passive, they can compound their capital for decades investing in what they know. Studies have shown that the more passive the investor, the higher the chances for satisfactory long-term performance.

My goal should be to have a portfolio that produces slow and steady returns that I can live off of. If I get scared because my portfolio underperforms for a few years, and I end up switching at the worst possible time, I would likely never make any money investing in stocks. The real lesson here is to have a solid understanding behind my strategy, and then to have the patience to stick to it through thick and thin. If I sold my dividend portfolio holdings today and I invest everything in an S&P 500 fund, my dividend income will drop by 45 - 50%. This will be caused by the fact that I will have to pay capital gains taxes on unrealized capital gains and I will have to accept a lower current yield. This change would actually require me to spend more time working at a job that I might or might not enjoy. Since I am not a robot, I have a limited number of years on this earth that I can spend working, rather than enjoying life. In addition, index funds contain a lot of companies that do not pay dividends. And as we know, relying on capital gains works great during a bull market and prices move up. However, if prices are flat, as they were between 1929 - 1953 or 1966 - 1982 or 2000 - 2012, my portfolio will not last for long if it doesn't yield anything. Selling off stocks in your portfolio results in less stocks available over time. If prices do not grow fast enough, you will deplete your portfolio. Selling off chunks of my portfolio to live off is similar to cutting the tree branch you are sitting on. Why not just pick the fruit from the tree, and let it grow uninterrupted?

The problem with indexing is that there is no one-size fits all approach. Some index investors allocate 100% of their money to US stocks, others split it between US and international, while a third also add as much as 50% in fixed income. Each of those three types of portfolios will have different expected returns. In addition, the relative weights for large-cap versus mid-cap versus small-cap shares could affect expected returns as well. If you dig into international stocks as well, you have to decide between developed, developing, frontier, and then deep dive into large cap, small cap, mid-cap and growth versus value. The expected returns of each of those index investors will vary significantly. In reality,the past 8 years have been good for the dividend growth investor who is entirely in stocks. This not only includes the S&P 500 but also commonly used index portfolios where stocks and bonds are equally split, and re-balanced periodically. By investing mostly in US stocks in my taxable portfolios, I have done better than most index portfolio that held bonds or international stocks. I would expect that in the next 30 years, a portfolio of dividend growth stocks will do better than the typical index portfolio that holds 50% – 60% allocation to stock indexes, and a 40% - 50% allocation to fixed income.

When someone tells me they are going to sell securities from their portfolio, they are essentially telling you that they blindly believe the stock market will only go up during their retirement. This flawed thinking ignores past history, and sequence of return risks in the portfolio distribution phase. It also resembles the flawed belief by some homeowners between 2000 - 2008 that they can tap equity from their appreciating homes and spend the proceeds. Treating your house like a piggy bank, and relying on increases in house prices to live off turned out to be a poor choice. Spending too much time comparing yourself to the Joneses, is another folly people do. To me, comparing total returns of my portfolio relative to that of someone else's is a perfect example of keeping up with the Joneses. This can only lead to folly behavior.

I am not a big fan of dividend funds or dividend ETF's either. Even dividend growth funds tend to do bizarre things such as keep companies that have cut dividends for almost an year, as was the case of Citigroup in 2008. Another bizarre thing I have seen is when some companies are not included, or others are taken out, as was the case of Altria (MO) being dropped from the S&P Dividend Aristocrats index in 2007. A third example includes my purchase of Higham Institution for Savings (HIFS) in 2010, which was not covered anywhere else except on the list provided by David Fish.  As you can see, indexing does not work for my goals and objectives. However, it could still work for anyone else. Because I am the only one who truly cares about reaching my own goals and objectives, I create my own portfolios by picking individual stocks.

To reiterate the biggest danger in comparing to index funds is that any under or over performance produces no actionable insight for my portfolio management. On the contrary, it can cause me to abandon my strategy at the worst time possible, simply because I “underperformed” the index. With dividend growth investing, I would likely at least match total returns of S&P 500 over long periods of time like 20 years for example. This could include variations in under or over performance over periods of time of varying lengths. However, just because I underperformed for 3 years, it doesn’t mean I would underperform for next 3 years. Because of reversion to the mean, the 3rd year of underperformance might mean that dividend stocks are cheaper than the stock market as a whole. Therefore, they could provide much better returns for the next few years, relative to a market index such as the S&P 500. As usual, past performance is not a predictor of future performance.

The real reason why everyone encourages individual investors to buy index funds in the first place is because some individual investors are horrible at making investment decisions. Not only are they terrible at investing, but they are overconfident and overtrade, fail to stick to a single strategy because they are afraid of missing out on the next big thing. The common fallacy among inexperienced investors is that you need to find the next Microsoft to make money in stocks. Unfortunately, few ever find the next Microsoft, but many lose a lot of money in the process. In fact, these investors would have been better off simply buying and holding on to the original Microsoft in the first place.

(The conclusion that individual investors are terrible at investing is based on data I have analyzed from DALBAR. While I am sure DALBAR is a reputable organization, I have learned to always take information with a grain salt and some healthy dose of skepticism. This is because the information is used by financial providers, advisers and mutual fund companies in order to get clients. Since Dalbar's clients are financial services companies, DALBAR has an incentive to show how bad individual investors do on their own.  If you prove to investors that they need help from the financial industry, they are more likely to come and earn money for your company. There is an incentive for DALBAR to not compare apples to apples, in order to make a case against individual investors. So, as Charlie Munger says, "Never ask a barber if you need a haircut" )

The truth is that if you build a diversified income producing portfolio with companies that are purchased at fair prices, and you do little activity every year, you stand a chance to do pretty well over time.

I reached these conclusions after studying the performance of the original 500 stocks in S&P 500 in 1957 versus index, as well as the ING Corporate Leaders fund for the past 50 years. Did you know that S&P 500 index replaces approximately 4% of components every year? Did you also know that if you had purchased the original 500 components of the index in 1957, and held on for the next 50 years without doing anything other than reinvesting your dividends, you would have outperformed the index? Did you also know that S&P 500 frequently makes changes to its index methodology, which would have reduced past performance numbers?

In addition, if you study the history of the ING Corporate Leaders fund, you can gain a glimpse of the potential in a truly passive buy and hold portfolio. The trust was formed in 1935 with a list of 30 blue chip dividend paying stocks. Given the mergers, acquisitions, dividend eliminations, the list is now down to 22 companies. Over the past 50 years, the fund has managed to return 10.20%/year, versus 9.80% for the S&P 500. The trust sells when a company eliminates dividends or stock price falls below $1.

To summarize, it looks as if the only way to achieve my goals and objectives is by constructing portfolio myself, by purchasing companies with sustainable advantages at fair prices, and then holding passively for the long run. Being passive should be the goal, as selling is usually one of the biggest mistakes investors make. It is a mistake because few can just sit tight and enjoy the ride while ignoring the noise out there. Frequent churn could be costly. Cutting investment costs to the bone is also very very important. If you have a $1 million portfolio invested in index funds, you are likely paying $500 - $1000 every year. You can easily purchase stakes in 30 – 40 of the largest dividend paying blue chips listed in America, and just hold them for eternity. Some of those will fail in the next 40 - 50 years, others will merge or be acquired or spin off countless subsidiaries. A third group would likely still be around 40 – 50 years later, showering you and your descendants with more dividend income than you ever imagined in your wildest dreams.

Update: I have received a tremendous amount of hate mail from index investors related to this article. One index investor just wished me that my portfolio goes to zero. I wonder if they realize that their wish means S&P 500 will also go to zero.

Full Disclosure: Long MO, HIFS

Relevant Articles:

Dividends versus Homemade Dividends
Why I am a dividend growth investor?
Dividend Portfolios – concentrate or diversify?
Are performance comparisons to S&P 500 necessary for Dividend Growth Investors?
How to be a successful dividend investor


  1. You make strong points. For me, the value in benchmarking against a broad index is it lets me know whether I am making the right decision by choosing individual stocks. If I can't beat the index, I should capitulate and index.

    1. Well, the decision depends on how long you do "worse" than this benchmark and identifying the reasons behind this underperformance. Anything less than 5 years is pure noise. However, the real question is - are your goals and objectives to beat the return of someone else, or are your goals and objectives to generate consistent returns to live off? For most investors in retirement, the goal is to generate regular cashflow from their investments to live off.

  2. Very nice post!

    Successful investing is's just not easy to execute. Investors should spend more time focusing on psychological pitfalls and fulfilling their realistic needs rather than trying to beat a benchmark.

    1. You have some very good points. Knowing yourself, your strengths and weaknesses, and your goals and objectives is very important. Achieving a consistent return is more important for most investors in retirement than beating a benchmark. If someone beat the benchmark by 1%/year, but the benchmark went nowhere for 15 years, they would have failed as an investor. I am often surprised how indexing is being sold to investors who know little about investing, and would not be able to stick to this strategy during the next correction.

  3. Would be nice to see sample portfolios and what to expect in dividend income i.e. $250,000 vs 500,000 vs 1 million - now vs 10 yrs vs 20 yrs from now so we know if we are on the right track.

    1. You can simply multiply expected dividend yield times the initial portfolio size in order to come up with the answer to your question. A dividend growth portfolio that yields 3% today but grows dividends by 6%/year, and where dividends are reinvested could generate yields on cost of 6% in 8 years, 12% in 16 years and 24% in 32 years. These are all estimates. You might enjoy these series:

    2. This is where basic high school arithmetic should come in. Sadly, I doubt compounded interest is even taught any more. I think it's helpful to make projections using real returns instead of nominal returns.

  4. Since few of us are likely to beat the total return of an S&P 500 index over a 10-20 year time frame, wouldn't an investor be better off in that index ETF than in a diversified basket of income-producing stocks -- assuming he had enough capital deployed to meet his income needs from the lower-yielding index?

    1. When you say “most investors”, you do realize that you include the majority of people who treat stock market like some sort of gambling, right? You also realize that “most investors” probably are not saving enough, and most probably have all of their retirement assets in a 401K or some IRA. So yes, some of those investors who do not want to bother learning about investing might benefit from indexing. Many will not do well with index funds however.

      The problem is not whether you choose an index fund, a diversified portfolio of stocks, apartment houses, REITs – the problem is creating a plan, a strategy to accomplish plan, and to stick to it through thick and thin. (as a side note, index investors in Vanguard S&P 500 index fund have done worse than the index in the past 15 years)

      An index fund is nothing magical – it is a portfolio of stocks compiled by someone else. If I build a diversified portfolio of 50 equally weighted blue chip dividend stocks, I reinvest dividends, never sell anything nor re-balance, and hold for the next 20 - 25 years, my annual returns will be close to that of Dow 30, S&P 500, whatever. Plus, that portfolio will generate an ever growing stream of dividend income for me, and I won’t have to worry about stock market being flat for the next 10 or 15 years.

    2. Agree. Plan your work and work your plan.

    3. "If I build a diversified portfolio of 50 equally weighted blue chip dividend stocks, I reinvest dividends, never sell anything nor re-balance, and hold for the next 20 - 25 years, my annual returns will be close to that of Dow 30, S&P 500, whatever."

      I agree with that. But then why spend all the time and effort building your own portfolio rather than just putting your money in the index? If your returns are close to the index, then by definition your portfolio longevity will also be close to the index, and your effort hasn't bought you anything. It only makes sense to put in effort to build your own portfolio if you believe that you will outperform a no-effort alternative.

      And so that's the one point where benchmarking against an index can provide actionable information: is my effort actually worthwhile? "Meeting your goals" is nice, and I completely agree that schizophrenically chasing strategies is a bad idea, but it also doesn't make a lot of sense to keep your strategy in a complete vacuum. Say your goal is to travel from California to New York. You can start walking, and a month later, in the Nevada desert, you will still be "meeting your goal". But by benchmarking against the highway alongside your path, you may notice that the "automobile" strategy is moving people towards the exact same goal more quickly, safely, and reliably. Do you keep trudging along, happy that you're "meeting your goal", despite the fact that you've now been made aware of a more-efficient method to meet that goal?

      To be clear, I'm not saying that indexing is necessarily an improvement on your current strategy (except that the required effort is far lower). I'm just saying that periodically reviewing your strategy in light of new information is a sensible thing to do. Maybe walking penciled-out as the most-efficient strategy before you started your trip, but then someone invented the automobile, or the Star Trek-transporter, and that totally changes the math. Or maybe no new technology was invented, but the miles-per-day that you can actually walk are much lower than what you projected when you chose your strategy, or your food costs are much higher, etc. It seems you owe a responsibility to your future self to at least keep your eyes and ears and mind open.

    4. 1. Sequence of return risk is real if you rely only on capital gains, and prices are flat when you retire you will eat your capital
      2. Amount and timing of capital gains is unpredictable
      3. Dividends are more stable than capital gains. So it makes sense to use them to pay for retirement
      4. So we might get same average returns, but a capital gains heavy portfolio is riskier.
      5. Entry valuations matter
      6. The goal is not to beat anything - the goal is to live off portfolio. If portfolio provides you what you need, then keep your portolio.
      7. I used example that 50 stocks will have close returns to index, to show that dividend stocks can produce capital gains over time.
      8. It is important to find a strategy that works for you and stick to it. If indexing works for you - stick to it. DGI works for me, and will hopefully accomplish goals by end of decade.
      9. Time to craft, an execute my retirement plan is well worth it - it will pay dividends for decades down the road ( and hopefully help underprivilidged relatives and causes after that)
      10. You are correct that someone has to remain flexible. I am afraid of indexing becoming too popular, or investors investing in indexes regardless of valuation or without understanding risks behind stocks could make it risky. What would the effect on corporate policy be if major holders of stocks do not care and are taught that it is not worth it to exert any effort? Other than that it could work for 80- 90% of people who don't touch their stocks and keep contributing for 30 years. The problem is - I have seen index investors who would sell a quarter of their index funds in order to buy another index fund. The gambler mentality is very scary.
      11. Funny you mention the road analogy - what would make you switch out of indexing? Have you thought about that?
      I actually view investing similarly to Christopher Columbus looking for India, and instead discovering America. The future is unknown – it was unknown for the investor of 1899 that Russia and China would wipe-out shareholders in 20- 50 years ( unfortunately for some Russian and Chinese capitalists – it was literal as well )

    5. Skyrefuge,

      Have you seen the movie office space? In the beginning, everyone on their way to work is stuck in traffic and cars are not moving. The fastest person is an elderly gentleman who can hardly walk, yet he moves faster than everyone else slowly on the sidewalk. So even if you have a car, this does not guarantee that you will reach your destination. Things can go wrong – you might not know how to drive, you might run out of fuel, you might get into an accident, you might get lost, your car might break down or you might be stuck in a traffic jam.

      Using your analogy, if everyone is in index funds at the same time ( using cars), then road will be jammed at the same time, and the people that will get anywhere will be those who can walk.

      Remember the story of the turtle and the hare – slow and steady wins the race.

  5. "Did you know that S&P 500 index replaces approximately 4% of components every year? Did you also know that if you had purchased the original 500 components of the index in 1957, and held on for the next 50 years without doing anything other than reinvesting your dividends, you would have outperformed the index?"

    No, I did not know that. It sounds similar to data indicating that you should buy stocks when they are being replaced in the Dow, like AT&T which was recently replaced by Apple. It's hard not to play with the bar of soap, isn't it?

    1. Did you know that Vanguard 500 Index doesn't hold the exact stocks in the index? They use numerical techniques which let them avoid buying and selling at inopportune times. It also aids in the tax efficiency of the fund for taxable investors.

      One of the sources of "float" which is other people's money that Warren Buffett likes so much is the deferred taxes that is owed but never paid until the underlying security is sold. Before rushing headlong into a dividend portfolio, one should calculate the worth of this float, especially over many decades. Then the case for one's own portfolio isn't so clear.

    2. So you are saying that Vanguard does not follow the rules of the index it is supposed to replicate? That's fishy. You know, if I want to order a steak, I expect steak, not tofu.

      And yes, additions/removals from S&P 500 have subtracted from expected returns between 1957 and 2003 – per Prof Siegel. Most dividend investors I track rarely sell, and have much lower turnover than the S&P 500. So they do generate substantial deferred taxes when they buy and hold forever. This cannot be said for the S&P 500.

    3. Hi Keith,

      Turnover could be costly for portfolios in aggregate. I believe the goal of Dow is to be representative of the US economy. However, it looks like they make changes to it every few years or so. I would be curious to see how an investment in the original 12 stocks from 1896 would have done relative to the Dow. I know they dropped IBM in 1939, which was right before it went up a lot.

      I only have the data that the S&P 500 has added and removed companies, and has altered its structure multiple times between 1957 – 2003. As a result, the changes have subtracted from returns. The goal is to be as passive as possible – time in the market is better than timing the market. And you are right about the bar of soap – the more you handle that portfolio the smaller it gets.

    4. From Vanguards' prospectus,

      Primary Investment Strategies
      The Fund employs an indexing investment approach designed to track the
      performance of the Standard & Poor‘s 500 Index, a widely recognized benchmark of
      U.S. stock market performance that is dominated by the stocks of large U.S.
      companies. The Fund attempts to replicate the target index by investing all, or
      substantially all, of its assets in the stocks that make up the Index, holding each stock
      in approximately the same proportion as its weighting in the Index.

      Vanguard was in a legal battle with Standard and Poor's some years ago over licensing fees. Over the years the name changed from Vanguard SP500 Fund to simply Vanguard 500 fund.

      I am not saying Vanguard does not replicate the index. I am saying they do it in such a way as to minimize the adverse effects of changes to the SP500 index to fund shareholders. I doubt their actual technique is known publicly.

  6. DGI,

    Couldn't agree more. All that matters is that your income is covering your expenses by your expected time frame. As long as you're meeting your goals and expectations, it doesn't matter what the S&P 500, Russell 3000, or Jim down the street are doing.

    But, as you mentioned in an earlier comment, picking a diversified basket of high-quality dividend growth stocks will likely give you "market" returns or better over a long period of time anyway. In my view, you're simply taking the "best of the best" and avoiding the rest.

    Best regards!

    1. Hi Dividend Mantra,
      I agree totally with you. We both pick blue chip companies that are leaders in their sectors, which are profitable and have a track record of profitability. Therefore, a diversified portfolio with low turnover that is built to accomplish our goals is the ultimate winning strategy, that will help us hold through thick and thin for decades. In comparison to most dividend investors, the S&P 500 looks like an active hedge fund. Most index investors do not understand that S&P 500 is nothing magical – it is just a portfolio of stocks selected by someone. You are likely to receive the so called “market returns” with a diversified portfolio of 40 – 50 stocks – Dow Jones 30 has shown that it is possible with 30 stocks. And many seem to forget that dividend growth stocks do deliver total returns.

      Comparing results to someone else is perfect example of keeping up with the joneses . Some people never have enough. When I think about the janitor who died with $8 million, I think that he succeeded because he invested in what he knew and stuck to his strategy for 55 years. Sure he could have invested in something else, but chances are he wouln’t have been successful because it wouldn’t have been something he knew well – so he would not have stayed the course.

      In our cases, if we each manage to earn as much in dividends to cover expenses for the next 30 -40 years, it wouldn’t matter whether we do better than Joe down the street or S&P 500.

      Good luck in your dividend investing journey!

  7. I believe most of you folks must be much younger than I. In 1982 when I started investing with very small amounts of money available, mutual funds were the about the only way. Remember this was before the internet, let alone self directed internet brokers. Only mutual funds allowed regular small additions without huge brokerage fees, so their MER costs seemed ok. Now many former mutual fund investors see index ETFs as a low cost alternative. While I am now all in individual dividend stocks and love to study the market and watch my investments, I know many of my family and friends have other interests they believe are more important. These folks are better off in ETFs than mutual funds or heaven forbid an 'advisor'.

  8. I know I shouldn't compare with the S&P but I just had to pull out my data from last year and plug it into my excel spreadsheet! :(

  9. Young Dividend,

    This is why I wrote the article in the first place – an investor who has a strategy to achieve their goals sees they are doing “worse” than a benchmark for a short period of time, and then they do something. In reality, 1 year is too short of a time period to draw any conclusions. I would say 1 year is noise. Actually anything less than 5 years is noise. And if you listen to noise, you will never accomplish anything. If you switch today, you have taught yourself to switch strategies. If the stock market collapses, what is to stop you from selling everything? Big money is made by having a strategy and sticking to it, through thick or thin. Every strategy has tough moments, as well as good moments. If one cannot sit out through temporary weakness, then they will not really earn sufficient profits.

    Dividend Mantra above said something wise above – Let’s say you achieve your goal of being able to live off your dividend income in say 10 years. However, let’s say you end up underperforming S&P 500 by 1%/year over that time. Some would say you are a failure. I would consider you a success – you established a clear goal, within a clear timeframe, and created a strategy and plan to accomplish your goals. Even if you buy the S&P 500, there will always be someone, or some other strategy or some other index that did better than you. I guarantee you that. Are you going to continuously switch strategies, and in the end chasing performance?


Questions or comments? You can reach out to me at my website address name at gmail dot com.

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