Should dividend investors invest in index funds?

Index funds are perfect for most people who don’t want to bother about managing their finances and retirement. If your goal is to accumulate a certain amount of net worth in the future, and do not want to spend any time learning about investing, index funds could be your best solution. Therefore, index funds are great for 80% - 90% of the population out there, particularly if coupled with the tax advantages of 401 (k), Roth and Regular IRA’s etc. I own index funds in my 401 (K), because I cannot buy anything else there.

However, if your goal is to generate income in retirement, index funds might not be most optimal use of your resources. If your goal is to generate a positive stream of income that is not dependent on market fluctuations and grows faster than inflation (dividends), then index funds like the S&P 500 might not be for you. Dividend investing is probably practiced by less than five percent of the investing population, although it should be higher. Of course, do not take my word for that, as this percentage might be even lower than that. But this article is written for the dividend investor, who is willing to do some work, and not let their retirement in the hands of Wall Street.

With dividend growth investing, you put a portfolio of 30 - 40 equally weighted individual securities, from as many sectors that make sense, which are attractively valued at the moment. After screening for your entry criteria, you construct your portfolio, and sit on it, while receiving a rising stream of dividend income. You monitor your portfolio regularly, and only sell after a dividend cut or a crazy overvaluation. I have been doing this since 2008, and have experienced one cut in 2008, two in 2009, one in 2010 and none between 2011 and 2014. The proceeds from the sale of the stock which cut dividends is put to work in another company that fits your entry criteria. Typically, dividends are either spent or reinvested into more quality dividend paying stocks in the accumulation phase, in order to compound capital faster. The reason why relying on dividend income for retirement is superior to index investing is because dividends are more stable than capital gains, and are always positive. Therefore, if stock prices fall and stay down, the dividend payments will provide positive reinforcement to the investor, who would be motivated to keep holding and ignore market fluctuations. Otherwise, investors could panic during a market correction, and probably sell at the worst time possible. In fact, many investors do sell at the worst times possible. It is very difficult for the ordinary uninformed investor to see their portfolio being down 30% - 40% - 50%, and them losing several years worth of contributions in one bad year for stocks. Therefore, a lot of investors sell in order to stop the pain and stop their nest egg from dwindling down even further.

In addition, with dividend stocks, you are a buy and hold investor with a long-term view. You are not switching money from one company to another. Therefore, you are reducing reinvestment risk due to transactions, and have a much lower chance of generating lower returns that come out of frequent portfolio churning.

One reason against index funds, is that they include a lot of companies which do not pay ANY dividends. Therefore, the yields on index funds are very low, and not sufficient to live off of today. That’s why in order to live off this nest egg in retirement, you need to sell of a chunk of it every single year. This leaves you with a shrinking asset base, which is relying on continued growth in prices. Without the increase in stock prices, you are shrinking your asset base even further. If you retired at the end of 1999, you would have experienced stagnating stock prices, and as a result, you would have “eaten” more than half of your portfolio by now. I would not want to face the stress of eating into my capital when I retire. If I have $1,000,000, and I sell $40,000 worth of securities each year, I would be out of money in 25 years, assuming no inflation and no stock price growth. If the first five or ten years produce no increase in stock prices, then I face a high risk of running out of money. The last few years of living in such conditions would likely be horrible, as I would be counting every penny twice, and stressing over, while counting the days until I have to get a Wal-Mart job as a greeter out of necessity. The thing is that noone can tell you in advance whether the year you retire with index funds will be similar to 1972 or to 2000.

There are many flaws with index funds, particularly those on S&P 500, which make them poor choices for the enterprising dividend investor. The first is that there is a lot of turnover every single year, which is not good for wealth building. In fact, the turnover is approximately 3% – 5% per year on average. This means that every year anywhere between 15 and more than 25 companies are added and replaced by the benchmark, incurring fees for the investor. Buying and selling of stocks is the reason many investors underperform their benchmarks. For indexes like S&P 500, this frequency of asset turnover has lead to underperforming a purely passive portfolio of stocks. Did you know that the original 500 stocks of S&P 500 from 1957 outperformed the S&P 500 index by 1% point for 50 years? My previous article on the topic discusses research done to prove this.

The second flaw is that index funds are weighted based on float and market capitalization. This is to serve the mutual fund industry, not the investor. If you are a big shot mutual fund, and you want to raise 100 billion from investors, you cannot follow a passive strategy that requires you to put money equally between 500 companies, because for some the total amount of stock available to purchase might be less than $200 million. Therefore, some companies are ignored, at the expense of focusing on the biggest. In reality, the equal weighted S&P 500 has done better than the market cap weighted S&P 500 over the past decade.

The third flaw is that I do not know what criteria the index committee uses to include stocks in the S&P 500. Sometimes, they (just like any normal investor) follow the crowd into irrational exuberance and doing stupid things. For example, back in 1999, a lot of old economy stocks were thrown out of the index, and substituted for red hot technology stocks such as Yahoo! I would let you figure out for yourself how that worked out. The other sin of the S&P index committee is that it didn’t include Warren Buffett’s Berkshire Hathaway in the index until 2010. With my strategy, I can select the securities that fit my criteria, and live or die by their performance, as I am the one in charge of capital allocation in the family.

The fourth flaw with index investing that they are not a magic panacea for sure stock market profits. An investor who doesn’t know anything about investing, and is passively saving in index funds, can still lose money. They can lose money if they panic at the wrong times such as in 2008 – 2009 and sell everything. They can also lose money if they put money to work without taking valuation into account. The ordinary investor can find a way lose money even with idiot-proof index funds. In fact, according to Morningstar, most investors in the Vanguard 500 index fund have underperformed the index by 2% per year over the past 15 years. The investor also needs to focus on valuation at the time of investment. You should not just blindly put your money in the market to work, without taking valuation into account. For anyone who bought S&P 500 index funds in the late 1990s, they were simply chasing market returns. This was not a smart decision, and the subsequent decade of low returns proved that ignoring entry valuation at the time of investment is not a good strategy.

The other thing is that while index funds have rock bottom expenses, they could still add up over time. For example, if you have a portfolio worth $100,000, you will end up paying $100/year in management fees. If your portfolio is worth $500,000, you will be paying $500/year for life.

In contrast, if you built a portfolio of 40 individual dividend paying stocks, and paid a $5/commission for each trade, you would pay $200 in total. If you never sell, you would never have to incur commission expenses again. Therefore, with a $100K portfolio, you are better off cost wise in 2 years. For the larger portfolios you are better off in individually selected stocks on your own, rather than index funds. That is one of the reasons why people who have several million in equities always pick their own securities, rather than rely on index funds. Why pay someone else thousands of dollars in fees per year for passive investments, when you can simply create a portfolio of the largest blue chip stocks, and do nothing after that?

Over the past decade, more and more investors are beginning to embrace passive index investing strategies. I am just wondering to myself, what if everyone is in index funds one day? I wonder what the consequences and inefficiencies that could arise from this phenomenon of people believe you do not need to know what you own, as long as it is an index fund.

If at one point everyone is invested in index funds, this could create all sorts of inefficiencies in the market. For example, if a company asks shareholders to vote on certain issues that could be otherwise profitable, noone would vote, since conventional efficient market theory says all information is already priced into the stock. As a result, index fund managers might not even bother voting, as they won’t believe their vote counts. Next, since these fund managers might not vote, because they probably haven’t done any research to know enough about the companies they hold for investors in the first place. Therefore, corporate managers at those large companies would face few consequences from angry shareholders. I think that one of the reasons why CEO’s are earning such high compensations is because ownership is being delegated to mutual funds, and not individual shareholders. If Warren Buffett owned 30% of Berkshire Hathaway, and he let his son be the CEO, you could be 100% sure that he would fire Howard on the spot if he paid himself an exorbitant amount of compensation while not furthering shareholders’ interests. This is the reason why as dividend investors, it pays to have your interests aligned with management, especially when management has an ownership stake.

In conclusion, there are a few main ideas that enterprising dividend investors should take from this article.

The first idea is to buy and hold, and not engage in active trading. If you slowly built a portfolio of 30 blue chip stocks, from as many sectors that made sense, and you HELD ON, for several decades, you should do very well for yourself.

The second idea is also to educate yourself about money and investing AS MUCH AS POSSIBLE. The main idea is that you are the one responsible for your retirement future. You are the one whose retirement is at stake, and the only one who cares about succeeding. Therefore, you should be personally involved in the process, educate yourself and determine the best way to achieve your goals. Whether you end up buying dividend paying stocks, index funds, or daytrade internet stocks online, you are the person who will benefit or  lose from your actions. Therefore, do not outsource your retirement goals and dreams to a third party, whose only goal is to generate a commission or annual fees from you. Take your dream in your own hands, and get at it!

Full Disclosure: Long S&P 500 Mutual Fund

Relevant Articles:

- These Books Shaped My Investing Strategy
- Warren Buffett Investing Resource Page
- Are performance comparisons to S&P 500 necessary for Dividend Growth Investors?
- Buy and hold dividend investing is not dead
- Dividend investing timeframes- what's your holding period?