I am pleased to bring you a guest post by a blogger who is an expert on the stock market, Ten Factorial Rocks. I follow a free cash flow model (which roughly means that I need to see extra cash at the end of the month) but this may not be ideal for every one of you. Take it away TFR…
Investing: Dividends or Index?
In acquiring an education, we graduate through various stages, from primary school, middle school, high school and then, to college and graduate school. Life and personal finance are the same way as well. We mature through every experience that prepares us to take on higher order challenges and improve our ‘qualifications’, ultimately leading to financial independence.
In this article, I will be talking about one such ‘higher order’ topic in investing. It assumes that the readers have mastered the basics of personal finance. Like spending less than they earn (primary school), having a 3-6 month emergency fund (middle school), have no debt or have manageable cash flow/debt ratio (high school), and have invested in or believe in cash flow generating (or) appreciating assets like stocks or investment real estate for their long-term future (college level).
There are excellent resources available about the long-term benefits of investing in equities and specifically, equity index funds. Separately, there are resources available about dividend investing that a DIY investor can pursue. I wrote a detailed investing series comparing Dividends vs. Index because nobody truly compared the two investing philosophies from multiple perspectives without the bias of a blind advocate of the method they believe in.
Investing Philosophy Reflects Your Personality
Just like we can choose from multiple majors in college, in ‘higher order’ investing, we can take multiple paths to a secure retirement. One way is investment real estate, which Ben Davis believes in, and another way is equities that I believe in. If you choose the equities path, it becomes necessary to have the lowest costs of investment, in other words, invest efficiently. Even within low-cost equity investment universe, we can choose either very low cost index funds (some as low as 0.05% for US total market funds, and below 0.3% for international index funds) or create a diversified portfolio of higher quality stocks across multiple sectors that pay periodic (and often increasing) dividends.
It is the last point where there are divergent points of view. There are no absolute right or wrong answers once you reach this stage of personal finance – it’s like deciding which graduate school to select. You are already a winner and way ahead of millions of people in the journey to financial independence.
If you are a dividend investor with investment portfolio of $250,000 or more who makes, say, 20 trades a year, low trading costs will actually make your annual investment expenses lower than passive index investors. This is because index fund fees of 0.1% on $250K is still $250 per year, which is equivalent to 31 trades at $8/trade! These days, trading costs have declined so much it most online brokerages offer $2-5 per trade, or even less. On the other hand, the index fund fees in absolute dollars will only increase as your account size grows each year.
What is the right investment strategy here?
I am a strong believer in indexing as a strategy to build assets, that is, if you are in accumulation stage of life. You can continue to be an index investor for life, there is nothing wrong with that approach. However, if you are willing to understand how indexes are constructed, you will realize that a vanilla index fund, while it is diverse in terms of number of holdings, can expose you to more sectoral risks than you realize or are willing to tolerate. For example, S&P 500 index fund has 21% allocation to Information Technology sector and nearly 15% to Financials sector. These are sectors that do well when the economy is growing but have sharper declines during recessions than other sectors, like Utilities, for example. Utilities are only 3.2% of S&P 500 and they generally lag during raging bull markets but shine during declining markets due to their relative safety. Utilities and Health care, along with some REITs (not all), are considered ‘defensive’ sectors.
Better get comfortable with Beta
Collectively, all the market sectors, based on marked-weighted capitalizations, give total market volatility. This volatility is defined by the term beta. It can range from a low of zero (no volatility) to any number based on how volatile a stock’s price movement is. Cash has beta of zero, because its value is completely independent of the market.
By definition, since all volatility is calculated relative to the broader market, the S&P 500 index has a beta of 1.0. So, if your stock portfolio has a beta of 0.9, you should have 10% less volatility than S&P 500. Similarly, if your stock portfolio has a beta of 1.2, you are likely to experience 20% more volatility than the index. According to Modern Portfolio Theory, it doesn’t matter if the 0.9 beta is achieved by owning slightly less volatile stocks or by owning a portfolio of 90% S&P index and 10% cash (which has a beta of 0). The latter portfolio also has a weighted average beta of 0.9, and thus, theoretically, no different than the former portfolio of 100% stocks having a portfolio beta of 0.9.
But the reality that many investors face is different.
Stocks are the best asset class to own in the long run to achieve the highest possible return – on this, there is no dispute. But once you build a sizable portfolio, your focus may shift from wanting to bear the full market volatility. Also, you may choose to allocate different weightages to sectors. For example, you could decide to own dividend paying stocks across sectors such that you have say, 15% allocation to Utilities and a correspondingly lower allocation to Financials and Technology than what S&P 500 has. Doing so will cause your portfolio volatility (beta) to be 0.8-0.9 range, that is, 10-20% less volatile than the market. Similarly, you may choose to select high quality dividend paying stocks across the sectors in such a proportion to give you a dividend yield that roughly corresponds to your withdrawal rate. If you wish to live only on dividends, you can construct your investment portfolio of say, $1 million to deliver $35,000 in annual dividends. In this example, you can engineer your dividend portfolio to deliver a 3.5% starting portfolio yield, with an expected annual dividend growth rate of 5%. This takes care of both your current spending needs with a cushion for inflationary adjustments in the future.
Dividend investing is just a subset of equity investing, and it is not a different asset class that some assume. Dividends are more stable than capital gains, a fact that has been proven over 80 years (Ibbotson study). Also, dividend payers and growers, as a sub-class, have generated better overall returns than the index over the past few decades (Ned Davis Research).
My Dividend Investing vs. Indexing series examines the issue from the vantage point of an individual investor without any of the filters and biases of either camp that has its share of advocates. The individual investor is often a victim of the financial industry. I care about the individual investor because that’s who I am. Hope this series helps you in your thinking about an appropriate investment strategy for your FIRE journey. To understand this topic in greater detail, it would be useful to study my Indexing vs. Dividend Investing Series in detail. They are linked below for easy reference.
Part 1: This sets the background context and frames the debate from the context of passive income.
Part 2: This examines the flexibility of passive income in DGI using three investors in different stages of their lives with different objectives.
Part 3: This evaluates the role of dividend income in total returns regardless of which strategy you like to pursue.
Part 4: Choosing Indexing vs DGI is not an either/or strategy. What makes better sense depends on you and where you are in your investing journey.
Part 5: What about the risk of lagging the index in total returns? We examine this risk of DGI and the impact from both financial and life perspectives.
Part 6: Can you get the best of both indexing and dividend investing? Yes, you can. I share portfolio examples here on how to execute this strategy.
I would appreciate your comments either here or on my website.
BIO: Ten Factorial Rocks (TFR) owner is a 45-year-young corporate manager who values financial independence. Ten Factorial Rocks (TFR) was created to chronicle my journey towards retirement while sharing my learning’s, absurdities and pitfalls along the way towards my search for a more meaningful life. Wall Street finance and stock option riches have one thing in common – they never passed through my life! TFR is not just about financial independence. TFR is also about self-empowerment while getting to financial independence, and our search for a better, meaningful life (of which early retirement is just one milestone). We aim to educate, entertain, share life stories and analyze the oddities of the world around us. TFR – why the strange name?