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Dividend Growth Stocks vs. Index Funds
I’m fortunate enough to have access to a lot of financially smart people via Twitter. Recently, I’ve noticed quite a few individuals on Twitter touting the benefits of dividend stock investing. As an avid index fund investor myself, I immediately felt a sense of FOMO (‘fear of missing out’) followed by more FOMO.
As with most things in life, I jumped into it head first, confident that I could figure out what to do along the way. My first step was to buy the Too Much Money ebook by @DivCultivator (who I’ve followed for awhile on Twitter). I highly recommend this book to anyone who likes to be hands-on and learn for yourself why an investment is good or bad.
Step two was to follow the book. I set up a brokerage account that same day. I then had to do some account verification followed by depositing money into the account, both of which took 2-3 days each.
I like to jump into new financial endeavors relatively quickly and without too much risk. This helps me get over the mental barrier of starting, gives me something tangible to analyze later, and is done with money I’m willing to lose. I took a day to evaluate several stocks based on the criteria in Too Much Money, and landed on XOM (Exxon Mobile), largely because of how undervalued it seems due to the current oil shock. I bought 3 shares and joined the Dividend Investing Club! I wish there were more emotional hurdles along the way to make my origin story a little more interesting, but it was pretty cut and dry.
This was a fun experiment, and unless XOM cuts their dividends (which could happen), I shouldn’t have much to worry about. But if I’m going to do this long term, I need to know why I should spend my time on dividend stock investing over passive index fund investing.
First of all, this topic is extremely polarizing – I’ve seen forums and blog post comments go on for pages and pages with people going over advantages and disadvantages of each. Honestly, there are just way too many variables and we’d probably need some sort of machine learning algorithm with a TON of data to know 100% which is better for which situations.
To help make the comparison a little more manageable, let’s make some assumptions:
- We’ll have 2 portfolios (one for dividend growth and one for index funds – described below). Both portfolios will be held in taxable accounts.
- For dividend growth investing, I’m referring to a self-managed portfolio of dividend-income stocks, REITs, and MLPs rather than ETFs. This is much more interesting to me than the smaller returns of passively managed dividend ETFs.
- There are different strategies for both types of investing. For index funds, the strategy will be index funds that track the S&P 500. For dividends, it’ll be stocks that match the criteria in the ebook – relatively high yield, moderate growth, and strong management.
- Numbers will be based on historical returns and slightly idealized since I don’t have a ton of dividend experience myself.
- The end goal of either form of investing is financial freedom (to simplify things, also early retirement) – in this case, $50k a year.
Time to analyze! Let’s start small and work our way up. Here are the portfolios we’ll be working with:
Portfolio 1: Index Funds
This account will be made up of 100% index funds, and once we’re “retired”, we’ll make inflation-adjusted withdrawals.
I’m basing the withdrawal security on both the Trinity Study and the updated study numbers over 30 years, so let’s go with a conservative 3.5% withdrawal rate to better our odds of making it (4% has slightly better odds with more bonds added to the portfolio, plus I don’t believe management fees were included in the studies).
Portfolio 2: Dividend Growth Stocks
Here we’ll have 25+ hand-picked dividend growth stocks, diversified across various sectors. Based on the criteria in Too Much Money, we can assume a 5-7% dividend yield per year (the criteria varies depending on how interest rates are looking – currently in May of 2020 they’re extremely low).
Based on other articles I’ve read, 5-7% may seem higher than what many dividend investors target. However, it all comes down to investing strategies, and this is the one I’m currently going with. I was able to buy XOM at a 7.5% yield and it was my first time looking for stocks, so I’m forced to lean toward the side of “it’s possible”. Even if XOM had been at its normal price, it would’ve been a 5% yield, and there are always deals on the market.
For the sake of this post, I’m going to assume an average of 6% yearly yield. If you want to replace it with your own number, that’s totally fine (I went ahead and did it for you for 4% and 5% if you go to the whole way to the bottom).
My Preliminary Analysis – Does One Significantly Beat the Other?
Since I’m doing this comparison as a sanity check to make sure I’m not jumping into something crazy, let’s first see if there’s an obvious difference between the two. Like I said, we’ll start small and build up. So first – how much money would we need total to retire from either method?
Total Dollars Needed
If we go the index fund route, we’d need about $1,428,571.43 ($50,000 / .035). Remember, this is based on our conservative 3.5% withdrawal rate and the fact that we want to retire on $50k a year.
With dividend growth investing (Portfolio 2), we’d need $833,333.33 ($50,000 / .06) to retire. This is based on the 6% yield I explained above.
In terms of total dollars needed, dividends win by a long shot. But this is only part of the story. Next, we need to figure out how many years it would take for each strategy to actually reach their retirement amount.
Time to Reach Total Dollars Needed
Let’s assume we start both portfolios at $0 and contribute $1000 every month.
For index funds, we can expect a rate of return of about 6-7% after inflation (here’s a nice data driven article showing this up to 2009 – right when the economy started picking up again after the Great Recession). I want to stay conservative, but 7% is probably fair.
So assuming a 7% yearly return, it would take roughly 33 years to reach our number (using a spreadsheet to calculate, but this works too).
The dividend strategy in Too Much Money looks for companies with historical growth of at least 3% each year, outpacing inflation. Ideally, we’d beat inflation, but we’ll stay conservative and say we just match inflation each year.
Assuming a 6% yield every year (but this time assuming quarterly payouts/compounding), it would actually take almost 28 years to make our $833k. It goes to show how much of a difference 1% can make and that compound interest does the heavy lifting once the numbers get higher!
Time to Reach Dollars Needed With Dividend Taxes
But wait, you say – what about dividend taxes?? Fair enough. Although index funds do have taxable dividend payouts, we’re going to skip those for now (we’ll discuss this more in the “What We’re Missing” section below). Let’s just focus on Portfolio 2, since we’re counting on all dividends for our retirement.
To keep things simple, we’ll assume that our dividends are all qualified dividends (which isn’t a huge stretch). That said, we’ll be taxed at the capital gains rate, which for most people is 15%.
So every year, we’ll need to take away 15% of any gains made from dividends. This means that with taxes, it would take our dividend portfolio…almost 30 years to reach our $833k retirement amount. An additional 2 years – surprisingly not as bad as I thought it would be!
What We’re Missing And Why I’m Not Concerned
While this was fun and all, there are many caveats, some of which we’ll cover here. Since I’m not looking to publish a research paper, I didn’t want to spend a ton of time going over every possible scenario. I just wanted to get a general sense of how the two compare. Here are some of the things we’ll need to take into consideration when looking at these numbers:
- I imagine that we’ll be selling more shares of dividend stocks vs index funds over time as some companies begin to fail, others become extremely overvalued, and others cut/eliminate dividends. Selling shares is a taxable event, so this would cut some of our reinvestment potential. This isn’t a huge concern with index funds.
- The growth of index funds actually comes partly from dividends! About 1.87% average actually. This means 1) Some of the index fund returns should have been compounded quarterly as well, and 2) Some of the index fund returns should have been taxed.
- While the 3.5% index fund withdrawal rate was based on a 30 year run, our dividend portfolio could potentially last much longer since we rely on the dividends rather than the principal itself.
- We never accounted for dividend stock appreciation. So there’s an estimated 6% yield PLUS the stock appreciation. This one’s actually a pretty big point. As long as we’re picking carefully, our stocks should appreciate at least a little over time.
Even with all this missing info, I’m not concerned. Why? Because I know enough to take the next step. I’ve learned that this isn’t a crazy strategy and it can actually work. And that’s really all you need. Don’t get stuck in analysis paralysis or you’ll never start. Learn as much as you need to take the next step, and then GO. Once we start, the numbers will be a lot more useful anyways since we’ll base them off of real returns rather than assumptions.
PS – If you’re looking for more numbers in support dividends, check out this report by Hartford Funds.
A More Human Comparison
We went through lots of numbers, but before jumping into something new, we need to make sure non-numerical factors make sense. There are major pros and cons for both:
This one’s first because it’s the most obvious and probably the biggest factor for people. Index funds are easy. You buy a fund that tracks a certain index (since we used the Trinity Study, let’s go with the S&P 500), and you buy more and more funds over time. You may need to look at your portfolio once a year or so to rebalance your overall portfolio with bonds or something.
Dividend stock investing requires time. Time to analyze stocks, time to place orders, time to sell and look at markets. Once you have a system going, I could see the process taking maybe 30 minutes each week. But it’s still more than index funds. Index funds also provide automatic rebalancing. Hand picking dividend stocks means you have to rebalance yourself.
Index funds track LOTS of stocks. This diversification protects you. Let’s say you have S&P 500 index funds and 5 companies suddenly go bankrupt. You’re barely going to feel that. But if you have a portfolio of 25+ hand-picked stocks and even 2 of those go under, you’re going to feel that a lot more.
On the flip side, a company doesn’t just go bankrupt. There are usually signs and if you’ve been doing your due diligence, I’d bet there would be chances to sell and invest elsewhere before the company went under completely. You’d also want to make sure that no stock is more than, say, 5% of your portfolio.
Also, during a recession, I’d imagine that dividends don’t drop at the same rate as the entire market does. This could be another argument for dividend investing.
Education and Skill Development
For most people, dividend investing wins here. Since it’s not a set and forget type system like index funds, you’re forced to learn about the market and how to analyze stocks. If you get really good at it, this is the kind of skill that could make you more money down the road as your efforts compound.
If you’re looking for something easy that you don’t need to stress about too much (unless you’re about to retire), index funds are the way to go. You don’t need to worry about whether dividends will be cut or how a company’s stock price is doing.
However, if you believe that dividend investing can get you to financial freedom faster and with more stability, then long-term mental health means investing time now for those dividends.
Portofolio Cleanliness and Control
This is one I’ve heard a lot from supporters of dividend investing. The S&P 500 has a lot of good companies, but a lot of bad ones too. By hand picking stocks, you get to weed out all the risky companies and choose the ones that most align with your financial goals.
There’s also the morality aspect of things. You may be very against cigarette companies or companies that have anti-employee policies. You can choose not to support these companies with hand-picked stocks. Not so much with index funds.
My Strategy Going Forward
I have a ton to learn still, but I feel like this initial thought-exercise has been enough for me to come up with a basic strategy. Based on everything so far, I plan on continuing my path down this dividend growth road to see where it leads.
For now, my plan is to build up my dividend account to about 5% of my overall portfolio. This will give me the practice and experience I need without risking a ton of my net worth. I’ll be able to see how profitable dividend growth investing really is and whether or not it’s worth moving a significantly larger percentage of my investments to dividends stocks.
Word around the Internet is that I will probably not beat the market long-term. But dividends do seem more stable to me as a retirement plan than index funds at the moment. Even if my index funds last me until I die, there might not be a ton left after that. With dividends, I should be able to leave most (if not all) of the principal with my children and grandchildren. That’s legacy. Plus, I’m sure I’ll learn a ton along the way which I’ll be able to pass on to my kids so they can get started even earlier than myself.
Reliable income is key to financial freedom, so I’ll be making real estate, dividends, bonds a larger part of my overall portfolio.
PS – If you’d like to experiment with dividend growth investing yourself, my recommendation would be first checking out the Too Much Money ebook. It was a very inexpensive way for me to feel confident getting started and I’m sure it can help you as well. This link is an affiliate link so if you found the post helpful at all, considering using it for your purchase (at no extra cost to you). If not, feel free to buy it straight from Gumroad. Either way, the important thing is that you get started!
**With a dividend yield of 4% a year, you’d need $1,250,000 to retire. It would take you about 44 years to get there with taxes.
** With a dividend yield of 5% a year, you’d need $1,000,000 to retire. It would take you 35-36 years to get there with taxes. Crazy the difference 1% makes!
Which type of investing do you prefer? If you haven’t started yet, does dividend growth investing sound interesting to you? Let me know in the comments below!