Why dividend growth investing is better than index investing? This is a controversial topic and the subject of many debates. There are diehards in both camps. Dividend growth investing has gained in popularity over the past several years. There are many blogs and newsletters now focused on this type of investing. On the other hand, index investing, or ‘indexing’ has been around for a much longer time period. The concept can be traced to John Bogle, the founder of Vanguard mutual funds. Diehard enthusiasts of index investing are referred to as Bogleheads, which is their resource website. Their four is the Bogleheads 3 Fund Portfolio. Index investing was arguably profound at one time, but I would argue that the idea is now mainstream.
I think that dividend growth investing is better than index investing. That said, I do both. My focus and this blog are about dividend growth investing. But I use index investing for my retirement accounts for multiple reasons. In fact, for the great majority of investors investing in index funds is probably the simplest and best way to go. However, dividend growth investing has some advantages compared to index investing.
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What is Dividend Growth Investing?
Dividend growth investing is investing in stocks that pay a growing dividend over time. Dividend yield matters as well but high dividend yield is not the focus instead it is dividend growth. The dividends are reinvested during the early stages of investing or the accumulation stage. You generally should own between 20 and 30 stocks for diversification. Although the exact number range for diversification varies based on the research. Not all the stocks should be in the same sector, again for diversification. The reason that you diversify is that at any given time some stocks perform well, and others perform negatively. Diversification reduces correlation between stocks and reduces risk.
Most dividend growth investors start with a handful of core or foundational stocks and add to it with time. The growing dividends increases the dividend stream. At some point in the future when you retire the dividend stream becomes income. It’s really quite simple.
What Kind of Stocks Pay a Growing Dividend?
Dividend growth stocks are categorized by the consecutive number of years that a company pays a growing dividend. Companies that have done so for 50+ years are referred to as Dividend Kings. Companies that have paid a growing divided for 25+ years are known as Dividends Champions. Those that have increased the dividend for 10 – 24 years are called Dividend Contenders. Lastly, companies that have paid raised the dividend for 5 – 9 years are known as Dividend Challengers. Take a look at the dividend growth stocks lists for U.S. and international stocks.
It is no small matter to get to the 50+ year mark. There were only 42 companies on the list at the start of 2023. This is out of nearly 6,000 companies listed on U.S. stock exchanges (NASDAQ and NYSE). So, this is a pretty select group. Many companies struggle to even make it to 25 years due to recessions, and in some cases poor management decisions as seen in the Dividend Cuts and Suspensions list. At the latest update there were 307 companies on the list. This is not a small number and represents over ~10% of companies that pay a dividend.
What is Index Investing?
Index investing is pretty much the idea of investing in a group of passive low-cost index funds that track benchmark indices. This could be traditional index mutual funds, or it could be exchange traded funds or ETFs. You need to have a target allocation as an index investor. A common one is 60% stocks and 40% bonds, but the allocation could be whatever you choose. The ideal index investing allocation is also strongly debated. I will leave that discussion for another time.
Once you set your allocation and set your monthly investment amount into a handful of index funds you are pretty much done. In index investing diversification comes from choosing different asset classes or types of index funds. For instance, stocks with different market cap or in different sectors. In the case of bonds, it could be funds that focus on U.S. Treasuries, corporate bonds, municipal bonds, etc. Once per year you need to rebalance your portfolio to adhere to your target allocation. Again, much like dividend growth investing it’s fairly simple.
Now, let’s take a look at three reasons why I think dividend growth investing is better than index investing.
Fees for Investing in Dividend Growth Stocks Are Lower Than Index Funds
There is now no commission on stock trades at many brokerages. This is a significant advantage as there are essentially no costs for accumulating dividend growth stocks. Basically, my expense ratio is zero if I am a do-it-yourself or DIY investor focused on dividend growth stocks. Additionally, reinvesting dividends is generally free and automatic.
This has not always been the case. I recall that even 20 years ago the costs for a single trade were very high at $20 or so. This meant that buying $1,000 of stock had a 2% fee, while buying $5,000 worth of stock had a 0.4% fee and buying $10,000 worth of stock had a 0.2% fee. In the past this was higher than the expense ratio of most index funds.
Today, a fund like Vanguard’s Total Stock Market Index (VTSMX) has an annual expense ratio of 0.14%. This is very low. Still not having any commission on a stock transaction is even lower. Further, a mutual fund’s expense ratio is paid annually. The percentages seem small but let’s fast forward to your retirement. Let’s say you have $500,000 in VTSMX. Your annual fee is $750. This money is not going to you.
A dividend growth investor has more control than an investor in index funds. As a DIY investor that is buying individual stocks you have more control which stocks that you buy and at what price. An index investor relies on the underlying index. This index will change with time. For instance, the S&P 500, which is the underlying index for many funds, changes periodically. Hence, an index investor does not control which stocks he or she owns.
Let’s take a look at a direct comparison to a popular index fund, Vanguard Dividend Appreciation ETF (VIG). The top 5 stocks in the fund are Walmart (WMT), Microsoft (MSFT), Johnson & Johnson (JNJ), Visa (V), and United Health Group (UNH). These are all good stocks in my opinion, but you may not want to own one or more of them for a variety of reasons. For instance, I don’t own Walmart due to high competition in retail with Amazon (AMZN). Further, VIG has about 225 stocks in its portfolio. Some of these stocks do not have long histories of raising the dividend. Hence, do you really want to own them? I don’t.
Further, as DIY dividend growth investor you retain the voting rights. Of course, you must make sure that you vote annually. An investor in index funds generally does not exercise voting rights. Instead, the fund manager or firm votes for you.
Don’t Have to Sell Assets
As a dividend growth investor, you do not have to sell assets once you are retired. Instead, you are living off the dividend income stream that you have accumulated. In addition, this dividend income stream is fairly predictable and grows each year due to growing dividends. Even in a severe market downturn your cash flow from dividends is less likely to be affected. That said, dividends are not immune to cuts or suspensions. I maintain a running list of dividend cuts and suspensions during COVID-19. So, I am well aware that this can happen. However, even after dividends are cut or suspended, they tend to be restored and grow overtime. This happened to many REITs and banks after the Great Recession (2008 – 2009).
This is in contrast to one the underlying principle of investing in index funds where you sell 4% of your assets annually. This percentage is a widely acknowledged rule of thumb as the safe withdrawal rate. This means that you are selling off 4% of your index funds each year to pay yourself an income. This can work. But the problem as many experienced during the dot-com crash (2000 – 2002) and Great Recession is that you could be selling assets into a declining market. Your nest egg declined, and the 4% rule means that your income is lower.
Final Thoughts on Why Dividend Growth Investing is Better
Conceptually dividend growth investing and index investing have some similarities. They both rely on simple plans, saving more than you are spending, investing early and regularly, managing risk, and diversification. These concepts seem universal for success in investing.
Investing in index funds has some advantages. It is simple and takes relatively little time to master. You just pick a good set of index funds with low expense ratios and set your asset allocation. The advent of target date funds has made this even simpler. For this reason, I think for most people index investing can be the right choice, especially for retirement funds.
There are some disadvantages for dividend growth investing. It does take time and you need to educate yourself. However, there are plenty of resources for educating yourself. Dividend growth investing has some strong advantages as seen above. This method of investing can generate solid long term returns and dividend income streams. Hence, I think dividend growth investing is better than index investing.
Disclosure: Long MSFT, V, and UNH.
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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.