The great debate: Index vs Dividend Growth

If you have been reading this blog for a while, you know I’m a dividend growth investor at heart. You probably also know that rather than investing 100% in dividend stocks, we own some index ETFs. Essentially we are doing a bit of hybrid investing. In addition, we also have a small portfolio consists of individual stocks that do not pay dividends (I have not wrote about this portfolio though…should I?).

Recently Robb at Boomer and Echo wrote about Investing for Income in Your Accumulating Years. The article was inspired by Mark at My Own Advisor when he wrote about selling off a Canadian ETF to focus on more dividend stocks.

What Mark said:

“I’m striving for more dividend income from my portfolio; not relying on capital gains in our Canadian stock portfolio as we approach semi-retirement.”

Robb used to be a DGI himself until he sold off all of his dividend stocks and went with a simple 2 index ETF approach. In the article, Robb questioned the approach – focusing on dividend income now rather than focusing on total return during the accumulating phase. Robb believes by adopting a total return approach during the accumulation years and then switch to an income approach when you need the money is a better approach.

Imagine for a moment there are two investors, Income Ernie and Total Return Tim. Both Ernie and Tim are 30 years old and have saved $100,000 in their retirement accounts. They each hope to generate annual income of $30,000 by age 55.

Income Ernie invests in dividend stocks, focusing on blue-chip companies that have a track record of growing their dividends over time. Total Return Tim buys a couple of broad market index ETFs, opting for maximum diversification and a relatively hands-off approach.

Both Ernie and Tim save $10,000 per year for the next 25 years and earn a comparable 6 percent annual return. Each of their portfolios is worth $1 million, with Ernie’s spinning off $30,000 per year in dividend income, while Tim’s portfolio of ETFs yields just 1.8 percent, or $18,000 per year. Tim is $12,000 short of his income goal.

But after meeting with his good friend Ernie, Tim sells his ETFs and buys the exact same stocks that Ernie holds in his portfolio. Problem solved. Tim’s portfolio now generates $30,000 per year in dividends, the same as Ernie’s.

…it doesn’t matter whether you bought 1,000 shares of TD stock for $6 in 1995 or bought 1,000 shares of it yesterday for $63. The dividend today – 60 cents per share – is what matters, and in either case would pay you $600 every three months.

 

Valid points. However, I don’t think it makes sense to go with index during the accumulating phase then switch to dividend income investing during the retired phase. Stick with your investing strategy for the long term.

Furthermore, there is no guarantee that an index investing approach will provide a higher return than a dividend investing approach. Index investing will give you market performance minus fees, where dividend investing may out perform the market (you can also under perform the market of course).

 

Index vs Dividend Investing – What is better?

Is index investing superior than dividend investing? Or is dividend investing far better than index due to the regular dividend income?

It is a very tough question to answer and you will get arguments from both sides.

For me, index and dividend investing have their own advantages and disadvantages.

Index Advantages

  • Better diversification
  • Simplicity, tracking the market performance
  • Lower fee in the accumulating phase (assuming your discount broker has no fee ETF purchase)

Dividend Advantages

  • More control over stock selection and sector weighting
  • Predictable income
  • Income growth
  • No additional fee once you are in the retired phase (i.e. you’re living off dividend income and not selling stocks).

Index Disadvantages

  • Still have to pay management fees each year in the retired phase.
  • When selling funds in the retired phase (i.e. annual 4% withdrawal), have to pay fees to sell shares.
  • Many index funds in the market, which one to pick?
  • Lack of control over sector weighting. For example, if you are investing in Canadian market, you are heavily exposed to the financial & energy sectors. Is this desirable?

Dividend Disadvantages

  • Less diversification
  • Perhaps less growth overall since only larger companies pay dividends (you may miss out on the high growth startups)
  • Requires more time to evaluate and purchase stocks
  • Potentially higher fees during the accumulating phase from purchasing dividend stocks.

Whether you go with index, dividend, or hybrid that decision really depends on the individual. To me, index investing and dividend investing compliments each other and can go hand-in-hand.

 

Why did we decide on a hybrid investing style with focus on DGI

So why did we decide on a hybrid investing style with more focus on DGI? There are many reasons behind this investing strategy.

  • Predictable income
  • We maximize our TFSA and RRSP every year and contribute to taxable accounts as much as we can each year. This allows us to be tax efficient (Some may argue that we are paying unnecessary taxes on dividend income during the accumulating phase but that’s a different discussion for another day).
  • We like the ability to select stocks and control the sector weighting
  • Perhaps the most important factor to focus mostly on DGI is the fact that we do not plan to sell stocks once we are financially independent and have no active working income. We plan to rely on dividend income to cover our expenses entirely. We plan to pass down our dividend portfolio to our kids and their kids.
  • By not selling stocks in our dividend portfolio, we have a higher margin of safety.

Predictable dividend income each month

Final Thoughts

I don’t believe that one strategy is superior than the other. There are pros and cons for each strategy as indicated above. Some people will prefer index investing for its simplicity and diversification, while some will prefer dividend investing for the predictable dividend income and more control. Evaluate your needs and determine an investing strategy that is suitable for you. Whatever investing strategy you pick, index investing, dividend investing, or hybrid, it is important to have an investing strategy than have no strategy at all.

The most important aspect is to invest for the long term and stick with your investing strategy. Get in line and stay in line. Don’t jump back and forth between different investing strategies.

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46 Comments

  • Reply
    Ten Factorial Rocks
    May 23, 2017 at 8:11 am

    Good post Bob. I agree with you on the main message. Both DGI and Indexing work if followed diligently. It’s impractical to follow one strategy for 30 years and then switch over in your later years, when your experience with the new investing strategy is zero and also, doing this at an age when you should precisely not be making major moves like that with your big nest egg – not to mention capital gains tax implications. I wrote a series of articles on DGI vs Index which covers this and several points for interested readers: http://tenfactorialrocks.com/investing-series/

    • Reply
      Tawcan
      May 23, 2017 at 10:05 am

      Agree that it’s impractical to follow one strategy for 30 years then switch over in later years. If you’re an index ETF investor you probably wouldn’t have an interests to learn how to pick dividend stocks.

  • Reply
    Financial Rookie
    May 23, 2017 at 9:18 am

    I’m taking a dual approach as well. I’m using my employer account to grow my index position (only VFIAX is available anyway…) and using my IRA for my DGI position while still indexing it. VYM makes it super simple for me, which is what I like.

    • Reply
      Tawcan
      May 23, 2017 at 10:06 am

      Sounds like a great plan to me. 🙂

  • Reply
    Dividend Diplomats
    May 23, 2017 at 9:51 am

    Tawcan –

    You are right – investing and being in it is the key point. Try not changing your strategy and if you do – don’t do it often – as it will mess with the “timing” of the market – i.e. you may miss out on huge dividend growth rates in years that you switched to ETFs; and then if you see that happening one may think – oh I’ll switch back to DGI; and then only to find that the DGR slowed and the cycle continues. Sticking to one plan for the long-term is more than likely the higher suggested path!

    -Lanny

    PS – Yes you should definitely talk about that small portfolio!!! haha

    • Reply
      Tawcan
      May 23, 2017 at 10:06 am

      I would say you don’t even change your strategy and stick with it. The more you “switch” the worse you will do in the long run.

  • Reply
    SeekingTheDividends
    May 23, 2017 at 10:10 am

    Thanks for this article. I also do both, but I have my index ETFs mainly in my Roth IRA (index funds in my 401k), and individual stocks in my taxable acct. I like to have the dividend income accessible if I do need it before I hit that magical 59.5 age. Also my practicing both along the way I am learning valuable lessons which allow me to improve with each investment decision. Definitely stick with your strategy, no matter what it is. I the question between the 2 really depends on preference. I like DGI, as I like to see the payouts increasing each year. It annoys me that the ETF payouts fluctuate 🙂

    • Reply
      Tawcan
      May 23, 2017 at 11:07 am

      Yeah it’s hard to predict what ETF payouts will be like. That’s why I like DGI more. But some people like ETF better because they don’t want to receive income which would trigger income tax. It really comes down to your preference.

  • Reply
    Budget on a Stick
    May 23, 2017 at 10:11 am

    Holy crap! You are a mind reader! I was thinking about this topic this morning and planned to find posts to read tonight.
    I was wondering what the differences really were and why you would want to do it in the accumulation phase

    • Reply
      Tawcan
      May 23, 2017 at 11:07 am

      Haha I’m a mind reader alright. 🙂

  • Reply
    Dividend Daze
    May 23, 2017 at 11:01 am

    There is really no wrong way go to with either one you choose. Just depends on your overall strategy you developed when you started. If you enjoy buying stocks and keeping a close eye on your portfolio, then DGI may be best for you. As you mentioned, if someone is more hands-off, then it’s easy to just set it and forget it in index funds. As long as people are actively investing and stick to your market strategy, they will be fine in the long run.

    • Reply
      Tawcan
      May 23, 2017 at 11:08 am

      Exactly. I don’t think it’s one over the other. Nothing wrong doing a hybrid approach. The key is to stay in the market for the long term.

  • Reply
    Matt @ Optimize Your Life
    May 23, 2017 at 11:14 am

    I’d be really curious to see someone run the numbers on this.

    You pay the 0.04% management fee on VTSAX that you would not have to pay if purchasing individual dividend stocks. You have to pay trading fees for individual stocks that you don’t on VTSAX (assuming you have a Vanguard account). Dividend stocks are less tax efficient (assuming they are outside of a retirement account).

    But none of those numbers mean anything without being able to compare expected returns. If the expected returns are about even, then I’d imagine that index investing would ultimately net you more money. If dividend investing has higher expected returns than index funds, then it could be a different story.

    (Obviously there are reasons other than maximizing returns that someone might pick one over the other, as well. Full disclosure, I am entirely invested in index funds, mainly because of the simplicity.)

    • Reply
      Tawcan
      May 23, 2017 at 11:30 am

      The problem is, you can ever do a direct comparison. With DGI you own can own so many different stocks so it’s hard to calculate the return for individual DGI portfolio. When it comes to trading fees, you’re assuming you are using a broker that offers free ETF purchases. Some brokers in Canada still don’t offer that.

    • Reply
      Dividend Growth Investor
      May 23, 2017 at 2:33 pm

      Hi Matt,

      The interesting part is that we do not know in advance whether your selection of index funds will do better or worse than Tawcan’s selection of dividend growth companies.

      We also do not know if either of your fails to stick to your strategy for one reason or another. I have seen both dividend investors and index investors try to call the top of the 2009 – 2017 bull market for several years in a row now.

      Even if the expected returns are the same, and dividend companies are held in a taxable account, an index investor could still do worse due to the timing of their sales ( sequence of returns risk). Or they could increase allocation to bonds to smooth their ride, whereas a dividend growth investor may own more equities because they are focusing on the stability of the dividend payments.

  • Reply
    R
    May 23, 2017 at 11:16 am

    Too often, people fail to take taxes into consideration. As a tax specialist, I understand fully that in my situation having dividends now would cause me to pay more in taxes (Capital Gains are taxed at only 50% and only when you sell).

    Therefore, for me, the best strategy is a portfolio of index funds (5 funds: VXC, VAB, VCN, HXS, HXT) in RRSP, TFSA, and Non-Reg accounts. I’m going to stick to this strategy for a long time.

    DGI only works if you stick it out, and have the time and ability to evaluate companies. I’d rather get the market return less a small fee, than to try to beat the market. Doesn’t mean that beating the market cannot be done, but for every winner (someone who beats the market) there is a loser (someone who does not beat the market).

    • Reply
      Tawcan
      May 23, 2017 at 11:32 am

      Good valid points. Yes you have to pay taxes in dividends received now, if you invest in regular accounts. If simplicity is your preference than index is the way to go. But even index “picks” stocks. As pointed out by a reader, the S&P500 started as the S&P100 decades ago, is now 500, and there is a committee deciding which stocks get included in that package and which don’t. 🙂

      • Reply
        R
        May 23, 2017 at 11:44 am

        Yeah, fair enough. However, *I* don’t have to worry about picking and choosing. This frees up my time for other things, such as spending time with family and doing things that give me more value.

        When you’re calculating your return, you should add the cost of your time for picking / choosing individual stocks.

        Lastly, DGI may end up leaving a HUGE value behind. Perhaps that is the whole point behind DGI, but I wouldn’t want to leave a big nest egg when I cark it.

        • Reply
          Tawcan
          May 23, 2017 at 1:39 pm

          I suppose that’s why I have another portfolio that I purchase growth stocks. 🙂

          • wealth from thirty
            May 23, 2017 at 4:28 pm

            It would be delightful to read a post on that portfolio!

  • Reply
    ambertree
    May 23, 2017 at 11:37 am

    We are indexers for two reasons: simplicity and tax. As long as we a accumulate, that is what we will so.

    I do consider switching to dgi for retirement to avoid the mental problem of selling.

    I look with great interest to people that just retired or are about to retire to see how they will so with both strategies.

    I might even go hybrid and have some dgi income for basic living and etf for the extras

    • Reply
      Tawcan
      May 23, 2017 at 1:33 pm

      As stated in the article, a hybrid approach works best for us. So we’ll stick with that. 🙂

  • Reply
    Dividend Growth Investor
    May 23, 2017 at 2:00 pm

    I don’t really understand the dividend growth investing versus indexing debate. It is an apples to oranges comparison. The term “indexing” means different things to different people too ( so does DGI by the way).

    An index is a list of companies selected by a committee using some criteria. An investor that buys an index essentially buys a list of companies determined by someone else.

    An investor who builds their own portfolio of individual companies is essentially building their own index fund.

    We do not know in advance whether a portfolio of index funds will do better or worse than a portfolio of dividend growth stocks. In fact, even if everyone indexed, half of investors will do better than the other half. It is a mathematical fact.

    The important thing is to find out what your goals are, implement a strategy to get you there, and stick to it through thick or thin.

    The reason why investors fail is due to overtrading, lack of discipline, not creating and sticking to a plan due to fear/greed. I would also add some don’t do as well because they may pay too much in taxes/commissions/fees.

    However, the investor who lacks in discipline will not succeed even if they pay zero in fees/taxes/commissions,

    • Reply
      Tawcan
      May 23, 2017 at 7:08 pm

      Very true that an investor who builds their own portfolio of individual companies is essentially building their own index fund in some way. And yes the term index and DGI have very different definition with different individuals. Discipline is a very important aspect to being a successful investor.

  • Reply
    wealth from thirty
    May 23, 2017 at 4:42 pm

    Great post Bob. Agree 100% that it’s best to pick a strategy and stick with it – preferably one that lets you sleep at night and gets reasonable results for the effort. Index/DGI or even growth/value investing can have a place. I invest on value(/growth), but intend to utilise index funds as well and a lot of my retirement account is in low-cost index like funds. I think the tax side of the argument is an important one, but that’s a very individual factor. It’s preferable to pay large amounts of tax that are a tiny fraction of even larger earnings than small amounts of tax on mediocre earnings.

    • Reply
      Tawcan
      May 23, 2017 at 7:09 pm

      Best to pick a strategy that you can sleep at night. If going with growth/value investing means sleepless nights for you then there’s no point following that strategy.

  • Reply
    Ms. Frugal Asian Finance
    May 24, 2017 at 6:34 am

    I have invested in neither of this, so this post is really helpful. I’m risk-averse, so I’ll probably go with the less risky strategy despite the lower return. Thanks for sharing!

    • Reply
      Tawcan
      May 24, 2017 at 10:56 am

      Glad this has helped!

  • Reply
    Buy, Hold Long
    May 24, 2017 at 8:56 pm

    I was recently listening to a podcast and heard a lot of people call index investing dumb money. You don’t have to really make any hard decisions into what you are investing in. I also read that there are periods where index investing returns greater results and then when investing in individual stocks can sometimes outperform the greater market. It comes down to what your risk tolerance really is.

    • Reply
      Tawcan
      May 25, 2017 at 12:21 pm

      Indeed it comes down to your risk tolerance.

  • Reply
    eresc79
    May 24, 2017 at 10:30 pm

    I’m an indexer. When I found your blog I started reading about Dividend Investing. I found Dan’s series quite useful in debunking some of the arguments in favour of Dividend Investing (http://canadiancouchpotato.com/2011/01/18/debunking-dividend-myths-part-1/ and subsequent posts). I also read Banerjee’s Globe and Mail article that summarized it quite well:

    “Index investors believe dividend investors are merely one category of stock-pickers. They see dividend investing as an active investment strategy and since there is no reliable method of identifying which active investment strategy will outperform the market in the years ahead, indexers shun the dividend guys.

    For their part, dividend investors can point to a lot of evidence that suggests selecting strong companies with a track record for growing dividends is a market-beating strategy. The dividend fanciers also like the fact that dividend yields automatically increase as a stock’s price drops, giving dividend stocks a built-in counterbalance when markets turn down.

    There are entire books dedicated to each strategy. For many investors trying to decide which path to follow, it comes down to which book they read first.

    […]

    So what’s the verdict? While indexing wins in theory, it’s not by a landslide. In theory, theory and practice are the same. In practice, they are not.

    After speaking with many investors, I’m convinced that conviction is a stronger determinant of long-term portfolio success than the choice between indexing and dividend investing. A well-diversified dividend portfolio and a well-diversified couch-potato portfolio are both solid long-term strategies that share several commendable characteristics.

    The real risk lies in abandoning either strategy prematurely. Pick one and stick with it.”

    https://www.theglobeandmail.com/globe-investor/investor-community/trading-shots/index-or-dividend-investing-which-way-to-go/article13676369/

    So bottom line both strategies have plus and cons as you say. For me the simplicity, low time demand, less volatility of a diversified portfolio and greater growth make me stay as indexer. There are dividends in Index Funds too btw, just not as large.

  • Reply
    Micro Dividends
    June 1, 2017 at 3:46 pm

    When people ask me for investing advice, I tell them go with an Index Fund. As for me; I’ll build my own fund. Maybe I should listen to my own advice.

  • Reply
    Weekend Reading – Mental mistakes, great debates, broke NHL players and #money stuff - My Own Advisor
    June 2, 2017 at 5:11 am

    […] wrote about the great debate that will never end – index investing versus dividend growth investing.   At the end of the day I feel these strategies are more similar than different but no doubt […]

  • Reply
    Mr. Tako
    June 2, 2017 at 10:00 pm

    Hi Bob. Interesting post. I guess I look at the question a little differently — I view it really as a question of capital allocation.

    Buying an index ETF is just one kind of investment, just like a stock, a bond, or a piece of rental real estate. The question really isn’t about picking one or the other, it’s a matter of how you will allocate capital to your investments. Some will have greater growth, some will come with higher dividends, others with tax advantages.

    The real “secret to success” isn’t about picking one kind of asset and sticking with it until death, the secret is knowing how to allocate capital efficiently.

    • Reply
      Tawcan
      June 4, 2017 at 8:26 pm

      That’s a very good way to look into the whole index ETF vs DGI. I like your way of thinking/looking at things.

  • Reply
    One Dad
    June 3, 2017 at 9:25 am

    Well Tawcan, it’s nice to see that you realize the folly of using Yield On Cost.

    I am a DGI myself, but from Rob’s quote I am assuming that you agree all that matters if present yield. You should update that old post in which you state you will not need a million dollar portfolio because of YOC.

    Anyways, I use almost all DGI and I do have two indexes for my children’s RESP.
    So far, DGI has easily beaten the indexes, but that could change in the years to come

    Cheers

    • Reply
      Tawcan
      June 4, 2017 at 8:28 pm

      Sounds like we agree to disagree when it comes to YOC. It’s one of the parameters available to you. You can choose to use it, or you can choose not to. In my case I choose to use it. Will leave it at that.

      • Reply
        One Dad
        June 5, 2017 at 9:18 am

        It’s not a matter of having a difference of opinion TAWCAN.

        YOC is a backwards looking metric.

        An example of using it wrong would be to say that because of YOC you won’t need a million dollar portfolio to produce $30,000 income at a 3% yield because your YOC will be 6% at that time – surmising that your portfolio will only need to be $500,000k to product the same income.

        Sorry that is completely, 100% mathematically incorrect. This isn’t a difference of opinion.

        YOC is a neat way to measure the compounding effect of rising dividends. As long as you use it the correct way, it is a fine metric. You have not been using it correctly and it is leading you to make large mistakes in your assumptions on how large your portfolio will have to be at retirement to produce an income that you need.

        • Reply
          One Dad
          June 5, 2017 at 9:22 am

          A simple way for you to verify that I am correct is to look at your current portfolio and your income generated from it.

          Does that income correspond to current yield or your YOC?

          • Tawcan
            June 5, 2017 at 9:56 am

            The difference between you and me is that I don’t pay much attention on the current portfolio value.

            Current portfolio value = market performance. It can change every day.
            I pay more attention on the book value and how much that’s generating for me.

            Again, we’ll agree to disagree.

  • Reply
    Jordan
    June 8, 2017 at 6:40 am

    I like your philosophy of not switching from strategy to strategy often if at all. Like we’ve seen from historical figures just being IN the stock market over the long run is the best bet and the more switching you do the more of a chance you have to miss the long years of dividend growth or the years of capital gains.

    Jordan @ New Retirement

    • Reply
      Tawcan
      June 10, 2017 at 7:25 pm

      It’s not about timing the market but time in the market. 🙂

  • Reply
    Sascha
    June 17, 2017 at 9:48 pm

    when the time comes to retire and your indexing, you will start selling shares to cover your expenses. You are depleting the capital investment to do so. As your index follows the market you hope to make enough return to gain some back. What if the market crashes, your portfolio is cut in half and you go on to live for more years than you planned?
    I started with indexing but switched over to dividends early on. I rather have my dividends reinvested and dripped to get more shares and built a portfolio where I don’t have so sell the main shares to cover my cost of living.

    But to each their own, believe in your system whatever it may be and let’s hope for the best. Because at the end of the day nobody is the wiser.

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