Tuesday, September 5, 2017

Index Investing versus Dividend Growth Investing

One of the largest debates I have seen involves the debate on index investing versus dividend growth investing. Plenty of individuals who have already made a commitment to a strategy argue fiercely why their choice is superior.

An index investor will tell you that their way is superior to your way of investing.

A dividend growth investor will tell you that their way is better.

As usual, it is important to step back, and determine what drives those debates in the first place.

I believe that those debates are ego driven and not that useful for your ability to invest to reach your goals. Both sides may resort to bending statistics and facts to their liking, in order to “win” an argument. This is a dangerous exercise, because these individuals are actually learning how to justify their preexisting biases, rather than think objectively. When you double down on your position on a certain topic, you are focusing on your side of the argument, but ignore anything else. The debate is further driven down the drain by interested parties whole sole livelihood depends on selling you index fund portfolios or selling you dividend stock services.

These debates ignore the fact that index investing and dividend growth investing are very similar in nature.

For example:

1) Both strategies are essentially geared towards passive buy and hold investors
2) Both strategies focus on buying assets and holding tightly for decades
3) Both strategies focus on keeping activity as low as possible
4) Both strategies focus on keeping costs as low as possible
5) Both strategies succeed when earnings rise, dividends rise and intrinsic values rise
6) Both strategies discourage short-term trading, which is hazardous to your wealth
7) Both approaches favor a focus on diversification

The differences between these two strategies are not that different either.

Dividend growth investors want to live off the dividend income generated from their portfolios. Under the conditions we have today, a million dollar portfolio could easily generate a 3% yield or a nice income of $30,000/year. Dividend growth investors want to have this stream maintain its purchasing power during their retirement years.

Index investors want to live off their pile of index funds. They accomplish that by spending the dividend income from their portfolios and then selling a small portion of assets. Yields on index funds vary, depending on the fund you choose. Most index investors expect a 4% withdrawal rate, which can be increased by the rate of inflation over time. Elevated valuation levels however make some index investors more skeptical, enough so that they use a 3% withdrawal rate.

For example, with dividend growth investing you have to choose the types of companies to include in your dividend portfolio. There are several hundred companies that the investor can choose from, which would impact their individual performance down the road. Their weighting will also impact results. Your individual security selections will impact your results. But you are not picking stocks – you are building a portfolio consisting of individual stocks.

With index investing, an index committee has to choose the types of companies to include in an index. The index investor then has a myriad of indexes to pick and choose. The types of assets selected, their relative weights in the portfolio will determine how they do over time. For example, the index investor who put everything in US stocks a decade ago would have done better than an investor who bought indices on international stocks or emerging market stocks. An investor who owned more bonds in the first decade of this century would have done better than an investor who was heavily in stock index funds. Your individual security selections will impact your results. You are picking the indexes, for which the index selection committees has already picked stocks for. In addition, the specific period you are investing in will also determine your results.

Both approaches take a lot of time, depending on how things are structured. A diversified dividend portfolio can be set up so that it takes only a few hours per year. A portfolio of index funds could take a few hours per year.

Both approaches will suffer from behavior gaps. For example, if an index investor sells out during a correction, their long-term returns will suffer. If a dividend growth investor sells out during a correction, their long-term results will suffer.

Alternatively, investors in both groups will suffer if they try to time the market tops and go in cash waiting for a stock market drop.

I view my portfolio of dividend paying companies and my portfolio of index funds interchangeably. They will likely have similar expected returns over time. The amount and timing of those returns will vary however between these two portfolios from year to year. But over a long period of time, they should be fairly close.

For example, when I sold most of the dividend companies in my retirement accounts last summer, I bought index funds with the proceeds. A few years before that, I had sold some index funds and purchased dividend paying companies with the proceeds. When I do retire, I will sell those index funds and build a dividend portfolio to live off.

Ultimately, you success or failure with a given strategy depends on your ability to stick to it through thick or thin. If you continuously jump from one strategy to the next at the first time of trouble, you will never hit your retirement numbers.

Relevant Articles:

The Four Percent Rule is Dependent on Dividend Yields
The most important rule about dividend investing
My Dividend Retirement Plan
Four Percent Rule for Dividend Investing in Retirement

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