The answer is not black and white, there isn't one that is superior to the other, they both have their pros and cons and in the end it's up to you to decide which investment style fits you the most.
First what they have in common
The reason why everyone is trying to find which one is superior is because these strategies have so much in common - They are both very long term investment strategies, this long term approach works in the investors favor and minimizes risk. The reason why this happens is because in the future (uncertain time-span), the stock market as a whole will go up. Of course I don't have data to back this claim, as all the brokers so famously claim "Past performance does not guarantee future performance". However, I am pretty certain that as time goes by, the world will create more wealth. Every time someone spends their time building or creating something that has any form of value for someone, like writing this very blog post, they are creating wealth. This is further amplified by technological and scientific progress, which always happened, even in much darker times in our history.
So keeping in mind that the aggregate value of all the companies traded in the market will grow over time, it is a no-brainer that if given a long enough holding period, we will see our money grow together with the global wealth of the publicly traded companies. Of course in 50 years time, many companies might have just went broke or have been replaced by others who out-competed them. In this case, the whole market would be worth more, but our investment would have lost a lot of value. This means that the average individual wants to invest in the most stable and financial viable companies to minimize the risk of the company going bankrupt.
Index investing and dividend investing both seek to capitalize on this expected growth by investing in a diversified manner in the most stable and viable companies instead of the trying to guess which company will be the next major win (eg. Apple).
How they work and how they differ
Index investing is investing in a set of companies that are grouped together in an index because they share a set of common characteristics. The most famous and most usually followed is the S&P500. The stocks in this index are the top 500 of all US-based companies according to a set criteria which includes: market cap, liquidity, public float, sector classification, financial viability, length of time the company was publicly traded and listing exchange.
By investing only in the "top 500" companies, we can be almost sure that most of our companies will still be around long term and we are able to ride the wave of growth. On top of that, since we are invested in so many companies, we can really relax and pay no attention. This is what I consider true passive investment. If you don't feel comfortable or feel bored and uninterested in looking at companies fundamentals and learning how they operate, then go with index investing. You just transfer money every month and the magic happens, it doesn't get better than this. Based on past performance, this investment approach returned an average 10% yearly return. Pretty great for such low risk and no work approach, huh? In fact this is exactly what Warren Buffet recommends and will be doing with the inheritance he will leave his wife.
Dividend growth investment, while basing itself in the same principles is a different ballpark. First, it is active investment, not active in the sense that you are always buying and selling (that's trading), but in the sense that it takes a lot of work from the investor. You basically need to do your homework.
In this approach, you pick the companies you want to own (forget that you are buying stocks, you are buying ownership in companies), and you follow them by reading their announcements, quarterly and annual reports, making sure everything is in tune with how you expect it to go.
Because you have to focus your attention on the companies, you probably can't afford to follow 500 companies, you will have choose usually between 15 and 30. If you make sure you diversify the sectors in which you invest, this is enough diversification. Additionally, since you have to choose the set of companies that you feel are the most stable and viable, most people go with the major companies in each sector, which tend to have large track records of success, very strong finances and are very diversified themselves worldwide. Companies such as Exxon Mobil (XOM), Procter and Gamble (PG), Philip Morris (PM), Johnson and Johnson (JNJ), etc. Thus adding extra risk mitigation.
Imagine that you own 30 companies and one of them goes totally bankrupt losing you all the money you've invested in it. Even though this is something that almost never happens, you would have only lost 3.3% of your portfolio (and in the meantime you collected all the dividend payments).
The core advantage of dividend investment is that you are buying companies that you believe are at an acceptable price (instead of buying all companies no matter their valuation), have good fundamentals and pay a sustainable and growing dividend. Probably all the companies you choose to buy will have a lot of weight in the S&P500 anyway, so your investment will roughly end up following the S&P500 trend in terms of capital growth anyway. On top of that, these companies will pay higher dividends than the index fund (which pays the average of all the 500 companies) and since they were bought at a good valuation, you might outperform the index or minimize losses in the case of a market drop.
Another difference is obviously the fact that if you want to receive the dividends as income, the dividend investment strategy will have a higher income, even when the market is depressed and company valuations are down. On the other hand, the index fund will require you to sell chunks of your portfolio to achieve comparable income, and that can be particularly harmful during a recession years, where your stocks are extremely undervalued.
- Passive investment: Takes no work or effort for great returns
- Provides roughly half of the income of dividend growth investment
- Will charge you annual fees when your portfolio is finished and you just want to live off the income
Dividend Growth Investment
- Takes work and dedication to learn and understand how to evaluate companies fundamentals
- Since you buy solid companies when they are undervalued you can achieve better returns
- Provides a growing income stream superior to index investing
- Never requires selling assets to generate income (stronger during recessions)
- Most importantly: it's challenging and fun!
What about you, which one do you prefer?