The question of whether to go with a dividend strategy vs investing in an index fund is often something that comes up. While I do have an index fund investment that I hold, I actually favor a dividend investing strategy. Here’s why
I’m a happy holder of index funds in my 401k. I love my tax advantaged match. I don’t even see my money go into the fund or what it gets invested in. All I know is that my 6% match gets made every month. I don’t even see the funds go out of my bank account into the 401k because the money is all invested on a pre tax basis, taken out of my pay check before it even gets to my bank account. Now thats autopilot investing!
The beauty with the strategy is that the funds are invested regularly irrespective of market conditions, during both ups and downs in the cycle. I’m totally dispassionate about market conditions, which means I can take advantage of lows. Equally that may also mean that I invest even at peaks in the market. Over time, as markets invariably go up, I’m likely to be able to grow the value of my investment. While we may not be in a bubble, the markets certainly aren’t cheap either.
I’ve been occasionally asked the question of whether having your own dividend machine is better than owning an index fund. Frankly, there is absolutely nothing wrong with investing regularly and consistently in an index fund over time. It’s a good way to build long-term wealth.
In my view, the dividend machine is preferable to me for a couple of reasons:
Cash Flow for financial independence
The dividend machine gives me a constant source of cash flow that I can use to meet my expenses and fund an early retirement should I choose to do so. The best part of this is I am not reliant on selling down capital to meet my expenses, like I would be with an index fund. As we all know, markets go through ups and downs, and being forced to sell down capital to meet expenses when markets are in decline isn’t the best strategy .
Index funds pay limited dividends if they do pay dividends at all. Typically dividends that are paid out will be based upon dividends that are paid by the underlying stocks themselves. Given you will have a grab back of stocks that make up the index, some with progressive dividend policies and some that don’t pay dividends, that leaves you with a very small net dividend yield. As someone who wants to achieve early financial independence from dividends, thats not sufficient for my purposes.
Basket of Stuff
Investing in an index gets you access to a “basket of stuff”. Certainly if you are invested in a broad index like a “large company index” that can mean a number of different companies in a number of different industries with different rates of growth, different barriers to entry and different economic factors and risk profiles. There’s no real way that I can get on top of, let alone get comfortable with all that. Or perhaps that way I get comfortable is that I say I have “diworsified” any real company specific stock risk by holding so many stocks.
When investing in an index fund, you are investing in 100-200 odd companies with a variety of business models, strengths and weaknesses. Its difficult to have any degree of confidence that they are the best businesses. Your dividend machine is a self selected group of the strongest companies with the best business models that you personally research and monitor. The fact that these businesses pay out an increasing stream of cash means that they are among the most profitable, stable companies in your investing universe.
Weighted toward legacy
Index funds don’t weight equally by all companies. Index weightings are typically skewed more to the capitalization of the largest companies in the index. A negative outlook on the larger components of the index, either because they are slow growers or due to a negative performance will disproportionately affect the index also.
By nature of the way indexes are determined, they tend to favor legacy incumbent companies who have the largest weightings. It takes quite some time for emerging companies to displace something like AT&T in the S&P 500. To that end, indexes can sometimes have a rear view in more heavily weighting yesterdays leaders, which isn’t necessarily a bad thing, provided they still remain the best businesses with the widest moats.
However for some of the stalwarts such as ATT, Verizon and Pfizer, their best days of growth are arguably well behind them. That doesn’t mean they aren’t worthy companies for consideration, but perhaps not ideal candidates for growth. It can take many years for faster growing, more dynamic companies to grow sufficiently large enough in weight to be displace these incumbents.
Individual Stocks create Valuation opportunities
I’m a value investor at heart. I love pouncing on strong businesses that happen to be momentarily unloved by the market for one reason or the other. I’ve done my homework and I can identify an opportunity. I then want to swoop in for the kill. Investing in an index fund doesn’t allow me to fully apply my strengths of having a long-term investment horizon against the market weakness of short term mispricing and timing.
My long term horizon is the prime strength that I can apply in my David vs Goliath struggle against the algorithmic and high frequency traders and the billion dollar fund managers. I can’t as effectively apply this strength when buying into an index fund. Sure I can try to time the market and infer when it may be at a market low, but its much easier for me to analyze single dividend stock, work out whether its being unreasonably punished on short term concerns, and then go and execute my purchase.
Of course, to really believe this is a reasonable strategy, you have to believe that markets are inefficient and that they don’t efficiently price in all available information about a company real time.
Think markets are efficient? Carl Icahn announced a position in Apple stock in mid August 2013 that sent the stock price of a $400B company up 10%. No new market moving announcements such as new products or sale figures, just a recognition of value from an investor, that caused other follower investors to suddenly recognize the same value imbalance. An investment in Index funds doesn’t allow an individual investor to exploit the full value of short-term market mispricing of individual stocks in such a manner.
Index fund buying may create valuation problems
The thing with an index fund is that one way or another, you are likely picking up stocks that are at some point overvalued. An index fund replicates what ever happens to be in that given index and rebalances based on market valuation. In most instances, index purchases and rebalancing occurs when individual stocks have been pushed up in value to become bigger components of an index.
So your index actually encourages heavier weightings of components that may have become overvalued through rocketing up in price. While in some instances, the price rises may be earnings or fundamental driven, in other cases you may just be getting more exposure to cyclical bubbles and certain sectors that just happen to be hot (gold miners, social networking any one?)
When you combine the rebalancing that an index fund does in favor of components that have risen in value with the automatic, regular purchases that an investor does into a index fund, it likely means some portion of regular index buying is probably occurring where there is overvaluation. While I’m happy to pay a fair price for quality, I definitely don’t want to be buying into sector bubbles or overvalued stocks that aren’t quality. Thats a sure way to damage long term returns.
Small Fees that can really add up
Index funds have a reputation for having very low load fees. In fact, they can have expense ratios as low as 0.2% p.a That sounds great right? Well think about this. After a certain point in time, your asset accumulation phase will end and you will be in passive income mode, either selling stocks to fund expenses, or more preferably living off the passive income which your assets have generated.
While I know I still have a while to go on my accumulation phase, I can see the light at the end of the tunnel. At the point my accumulation phase is over, I will have minimal to no additional transaction fees in stock purchases or sales. My trading expenses will essentially come to an end. However the expenses in my index fund are just really starting to ramp.
I expect my portfolio value cross $1M in a few years and tick over to $2M at some stage during the next decade. In 20-30 years time, who know, it’s possible it could tick over $10M (now wouldn’t that be something!)
But think about the expenses on that size of portfolio in an index fund. That’s around $20k annually, on $10M. And its a growing problem, rising each year as your asset value increases. Don’t get me wrong, I think that would be a nice problem to have. Though who wants to bleed away several hundred thousand dollars in fees over a lifetime of investing if that can be avoided?