Thursday, March 13, 2014

Dividend Investing vs Index Investing

This is probably the most asked question from both new starters and experienced long-term investors. Which strategy is better - Invest in a low cost index fund or follow a disciplined approach to dividend investment?


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 Of course in 50 years time, many companies might have just went broke or have been replaced by others who out-competed them.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.

Summary

Index
- 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?



8 comments:

  1. One other aspect to this is the long-term, not just after the accumulation stage, cost effects of investing through a fund versus a individual dividend growth portfolio. It is actually something I am researching for a post right now!

    Either way, I don't think their is a right or wrong solution, because ultimately what fits for you and I might not fit for someone else!

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    1. Hey writing2reality,

      Agreed, they are both great strategies depending on your goals. The reason why I didn't mention the index fund cost on the accumulation phase is because even if you are buying companies yourself you have pay a transaction fee to the broker which I am expecting to be comparable to the fund charge. However, I would love to read your analysis on those costs to be sure (Of course some DRIP systems don't charge anything and that is even better).

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  2. DV,

    Good rundown here. I totally agree.

    I think they're just different styles of investing that are aimed at different people with unique goals. I think passive index investing is right for most people, but I can't imagine how dividend growth investing, when properly implemented, isn't superior over a long period of time. Especially after the accumulation phase, as W2R pointed out above, because, at that point, you're paying hefty fees on a rather large capital base.

    Best wishes!

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    1. Hey DividendMantra,

      Glad that it was a good read!

      That's exactly my view, specially since you are buying companies at a good valuation, I would expect it to produce better returns than shooting in every direction (assuming you are doing a reasonable job at valuating the companies). However, ultimately, when you decide to collect the dividends as actual income, the fact that dividend investment has no fees will probably make it a win over the long term no matter what.

      Kind Regards!

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  3. Great write up, I think index funds are best for individuals who simply want to "set it and forget it" and we all know some of those people. However, as you pointed out dividend investing is the way to go for me. I'm not looking for a huge nest egg when I retire, I'm looking for income. I believe investors are making a huge mistake in regards to retirement by focusing on the sum of their investment portfolios rather than the income that is generated from it.

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    1. Hi Marvin,

      Thank you! I'm glad that you liked it. I am completely in tune with what you are saying, and it is something I notice a lot. Many people are very focused on the value of their portfolios instead of the income it generates. A good dividend portfolio will keep paying and might even grow during major market collapses, allowing you not only to survive the crash but also make buys at good prices.

      Best!
      DividendVenture

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  4. Thanks for the article. It is always fun to read from DGI fans all over the world. :)

    For my portfolio I use a mixture of both. Right now I have 13 stocks incl. the usual suspects such as BAT, Unilever, Altria, Microsoft and german standard dividend stocks such as Munich Re (worlds largest re-insurer) and BASF (largest chemical company). I try to get my portfolio up to 25 stocks but are not sure with the levels we have right now. And I have to admit that I truly feel as an "owner" only with stocks. If I see somebody smoking Pall Mall, I love owning BAT. The same goes for Ice Cream or AXE from Unilever. In my opinion you don't have that "ownership-feeling" with funds.

    On the other side I also invest in index funds. I have a global dividend ETF as a core investment but try to hold some index funds as well for regions where it is difficult for German investors to buy single stocks (especially because of the German tax laws and the withholding tax from several countries). Specifically I mean index funds with focus on asian-pacific dividend stocks.
    I usually don't like black or white, so I decided for a little grey. :)

    Good luck with your journey, regards from Germany.
    Markus

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    1. Hello x_markus_x,

      It's great to hear from readers from all over the world as well! You seem to have a great portfolio, most of the companies you own are either in my watch list and some of them I own them myself. I'm completely on the same both as you regarding valuations nowadays making it hard to add more stocks.

      You're not the first DGI that I see that diversifies your investments with ETFS, specially like you say, for regions where it's hard for you to make targeted purchases, it looks like a very good approach. I intend to do so myself when my holdings grow a bit more.

      Glad to hear from you, good luck with your journey!
      DividendVenture

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