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Index Investing vs Dividend Investing


Published July 14th, 2016

Dividend investing advocates will tell you dividend investing is the best way to invest.

Index investing advocates will tell you index investing is the best way to invest.

Both have compelling arguments…

I am in a unique situation.  I run a dividend investing newsletter.  Obviously, I prefer dividend investing.  But that doesn’t mean dividend investing is right for everyone.  I’m not nearly as dogmatic on the subject as my work might indicate.

Many people who read Sure Dividend were long time index investors who switched over to dividend investing.

Other readers leave Sure Dividend to go follow an index investing strategy.

This article compares index investing and dividend investing.  It will help you determine which strategy is right for you.

The Crux of The Tradeoff

Dividend investing can be very cost effective.  In larger portfolio, it can be cheaper than index investing because there are no management fees at all – if you are a buy and hold investor.

The tradeoff between investing in individual stocks (dividend stocks in this case) versus funds is the tradeoff between focus and diversification.

Index investing by its nature gives investors cheap access to massive amounts of diversification.

Investors who select individual stocks eschew diversification in favor of concentrating on their best ideas.

For some people, this will result in poor results.  For investors better than average, it will result in better than average results.  For index investors questioning whether it’s possible to outperform the market, I recommend reading the Superinvestors of Graham and Doddsville.

This isn’t to say it’s easy to find favorable investments, but it isn’t impossible either.  It does take a lot of time, however.

There is compelling evidence that simple algorithms perform better than experts.

“Let’s take the data first: In my previous post I highlighted that there have been a raftload of studies comparing the predictions of human experts vs. those of algorithms, and that in the great majority of them the algorithms have been at least as good as or significantly better than the humans. In a meta-analysis conducted by William Grove and colleagues of 136 research studies, for example, expert judgments were clearly better than their purely data-driven equivalents in only eight cases.”

Source:  When Human Judgement Works Well, and When It Doesn’t by Andrwe McAfee

Using a rule based system that matches your investment needs and exploits well known market inefficiencies is an excellent place for individual investors to start in building their own focused (relative to index investing) portfolio.

With that said, index investing has one big advantage over dividend investing outside of the focus-diversification trade off…

Index Investing’s Biggest Advantage

If you are not interested in learning a great deal about the market then index investing is right for you.

This sounds almost derogatory, but it isn’t meant to.  Some people are passionate about businesses and investing.  Some aren’t.  Don’t pretend to be if you aren’t.

The biggest advantage to index investing is its simplicity.  It takes very little time to implement an index strategy, and very little research.

Warren Buffett has chimed on his advice for an index fund strategy.  Buffett’s index investing plan is simple:

While not explicitly stated, I assume the portfolio would be rebalanced occasionally (likely annually).

This portfolio would have an annual expense ratio of 0.10%.  A $1,000,000 investment would cost just $960 a year in fees.

Now, you can put a tremendous amount of time and research into picking the ‘perfect’ index investing strategy.  But you don’t have to.

And that’s the biggest advantage of index investing.  It is by far the most time effective investment strategy.

Who Is Index Investing Right For?

If you are looking for ‘average’ returns and a minimum amount of work, index investing is perfect.

I put ‘average’ in single quotes because average is not really average.  Most individual investors significantly underperform the market.

That’s not an opinion.  It is a fact.

Investing in an all-world fund like Vanguard’s Total World Stock ETF (VT) – which has an expense ratio of just 0.16% a year – may not sound exciting, but it will likely cause you to have much higher returns than your friends (despite what they may tell you about their latest great investment).

Additionally, it takes a tremendous amount of patience and determination to invest in individual stocks.  People thinking they are going to make a ‘quick buck’ by using their ‘superior intellects’ to crush the market are going to do anything but.

If you think you are going to pull out 30%, 50%, or 100% a year returns from the market by selecting ‘the best’ stocks, stop now and save yourself a lot of money.  Become an index investor.  Your investment account will thank me.

Note:  There are people on the internet who will sell you anything and play to the false belief that you can double your money quickly with fraudulent investment schemes.  Things that are too good to be true, usually are.

Index investing is right for the majority of the investing public.  Here’s who should be an index investor:

Advantages of Dividend Investing

I am a dividend investor.  I didn’t fall on my head one day and then decide to only invest in dividend stocks…

There is compelling evidence as to why dividend investing in general (and dividend growth investing in particular) works.  You can see 11 reasons to be a dividend growth investor here.

The first reason to invest in dividend stocks, in particular high quality dividend growth stocks, is that they have a history of excellent performance.

The image below shows the performance of various types of dividend investing versus non-dividend paying stocks from 1974 through 2014:

Dividend Growers and Initiators
Source:  An Economic Perspective on Dividends

Take a look at the historical performance of the Dividend Aristocrats below.  Dividend Aristocrats are stocks with 25+ years of consecutive dividend increases; they are ‘the best of the best’.

July Dividend Aristocrats List
Source:  S&P Fact Sheet
 

Now, you could invest in the Dividend Aristocrats ETF (NOBL), but it has a somewhat higher expense ratio of 0.35%.  The Dividend Aristocrats ETF isn’t the only interesting dividend ETF around.  You can see my analysis on the best dividend ETFs here.

One of the advantages of investing in individual stocks in general over ETFs is you have much greater control over you investments.

If you are retired, as an example, you might require a portfolio that yields over 3%.  You might also prefer low-volatility, low price-to-earnings ratio businesses with long dividend histories.  A portfolio with these characteristics can be created by investing in individual stocks.

In short, buying individual companies allows investors to tailor their investment accounts to their exact needs and preferences.

Index Investing & Dividend Investing Comparison

This section compares index investing to dividend investing on an item-by-item basis.  The following items are compared:

Time

Index investing is the clear winner when it comes to time it takes to invest.  Index investors need not keep up with individual stocks.  Dividend investors should periodically check in with the businesses in which they’ve invested to make sure the company still has a strong and durable competitive advantage.

Cost

Cost is not as clear cut.  For long-term, buy and hold investors dividend investing is likely cheaper.  That’s because there are no expense ratios associated with dividend stocks once you own them.

Dividends are taxed, but many funds pay dividends as well.  Holding your dividend stocks in a Roth IRA eliminates this disadvantage as well.

Here is some math behind investing in index funds versus dividend stocks:

That’s why it’s so important to keep portfolio turnover to a minimum.

I give the cost advantage to dividend investing but just by a hair.  It very much depends on how you invest.

Returns

I’ve cited return data for dividend investing in other places in this article.  Investing in individual dividend stocks with:

Will likely result in solid long-term returns.  When I say solid, I mean there’s a good chance total returns will be a few percentage points above the overall market.  Investors should not expect 30% a year returns or anything of that nature.

Index investors can invest in value or dividend funds as well.  The more these funds try to take advantage of specific factors that have historically resulted in greater long-term returns, the more they tend to charge.

Again, I give the slight edge to dividend investing in this category if done well.

Psychology & Risk

I much prefer to know what individual businesses I invest in.  When recessions hit, it’s easier for me to know that PepsiCo’s (PEP) underlying business isn’t going to suffer too much, no matter what happens to their share price.  People are going to keep drinking Gatorade and buying Lay’s no matter what happens to the overall economy.

In my experience, when you are familiar with a business and understand that you have fractional ownership in that business, it is easier to hold during recessions.

Dividend investors also typically watch dividend payments instead of the share price (to be fair, they watch both, but pay more attention to dividend payments than other types of investors).  Dividend payments are less volatile than share prices.

Case-in-point:  ExxonMobil’s (XOM) share price dropped from the mid 90’s to the high 50’s during the Great Recession.  It’s dividend kept rising every year.  If investors looked at the dividend instead of the share price, they likely would’ve rested easier.

Returns are not locked in until you actually sell.  When you hold great businesses with strong competitive advantages that are paying rising dividends, it doesn’t make any sense to sell your share of the business when you get a lower offer (when the market falls).  Sell rarely, and only if shares become significantly overvalued.

On the other hand, index investing has its perks as well.  A highly diversified portfolio can be easier for investors to hold, depending on your mentality.

If your thinking goes along the lines of ‘the world is not ending, and I own a large swath of the economy’, you likely won’t sell.  Additionally, index investors will likely be invested in some government bonds and possibly gold funds.  Both of which have a low correlation with equities and could very well be up while the overall market is down.  The permanent portfolio is a good example of this.

This greatly reduces portfolio level maximum drawdown and makes holding during recessions significantly easier.

If you view standard deviation as risk, there is no question that a well-diversified index portfolio will have a lower standard deviation than a dividend stock portfolio.

What is less risky between these two styles depends on how you think about them.  Overall, I give the edge to index investing because it (if done well) will have a much lower portfolio standard deviation.

Final Thoughts

Dividend investing and index investing aren’t really at odds with each other.  Both work well for different types of investors.

Having an investment plan and sticking with that plan are far more important than agonizing over dividend investing or index investing.

Both strategies can work well.  Some people will be more suited to index investing, while others will be more suited to dividend investing.

What you value will determine which is the better choice for you.  Investors preferring to minimize time analyzing financial info and volatility risk reduction will do best with index investing.

Investors looking to spend more time learning about businesses and wanting greater customization in their portfolio will do better selecting their own individual stocks (especially dividend stocks).

Thanks for reading this article. Please send any feedback, corrections, or questions to [email protected]


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