The great debate: Index vs Dividend Growth

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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 two 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 written about this portfolio though).

When I started investing in stocks, I purchased individual dividend stocks. Back then, I didn’t know anything about index ETFs. After a few years of our financial independence retire early journey, I realized that asset and geographical diversification are important, hence for investing in index ETFs, too.

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 two index ETF approach. In the article, Robb questioned the approach – focusing on dividend income now rather than focusing on a 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 termget in line, stay in line!

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 outperform the market (you can also underperform the market of course).

Interesting, when I look at my past performance for the last few years, I have managed to outperform TSX with our dividend portfolio.

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
  • A more predictable income
  • Income growth, especially organic dividend 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.
  • There are many index funds in the market, which one do you 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?
  • Lower MER the better, but when do you stop chasing the lowest MER?

Dividend Disadvantages

  • Less diversification, potentially geographically and asset.
  • 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.

And let’s not important the most important point here – whether you invest in index ETFs or dividend stocks, at least you are investing your money in the market and letting your money work hard for you. It is a far better approach than hiding your money under your mattress.

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

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

  • Predictable income. Knowing when dividend paying stocks pay dividends has allowed us to accurately predict our monthly income. This can become quite useful when we start living off from our dividend income. Obviously during the months where we get distributions from ETFs, it becomes slighly harder to predict the monthly income, but this can be a good problem to have.
  • We maximize our TFSA and RRSP every year and contribute to taxable accounts as much as we can each year. (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). For the most part, by maximizing our TFSA and RRSP every year, we are being quite tax efficient.
  • We like the ability to select stocks and control the sector weighting. I have an interesting in learning about stocks and reading annual and quarterly reports. By investing in individual dividend stocks, I’m allowing myself to learn more about the companies and exercise my brain muscles.
  • 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 in the future. We want to create a legacy for future generations. This is very different than the typical retirement plan of collapsing your entire investment portfolio by the time of death.
  • By not selling stocks in our dividend portfolio, we have a higher margin of safety. Most of the companies that we own have been paying dividends for many years, some even have been paying uninterrupted dividends since the late 1800s. I’m confident that even during a recession, our dividend income will be quite stable. This won’t be the case if you are relying on 4% portfolio withdrawal during retirement years. Since the portfolio value will most likely drop during a recession, you won’t be able to withdraw as much based on the 4% withdrawal rule. Meanwhile, dividend income should remain somewhat stable.
Tawcan Apr17 dividend chart
Predictable income each month

Final Thoughts

Index ETF investing or dividend investing? I don’t believe that one strategy is superior to the other. There are pros and cons for each strategy as I have outlined 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.

I truly believe it is crucial to 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. And let’s not remember, investing your money in something is better than not investing 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.

Written by Tawcan
Hi I’m Bob from Vancouver Canada, I am working toward joyful life and financial independence through frugal living, dividend investing, passive income generation, life balance, and self-improvement. This blog is my way to chronicle my journey and share my stories and thoughts along the way. Stay in touch on Facebook and Twitter. Or sign up via Newsletter