Monday, February 9, 2015

Dividend Growth Investing vs. Index Investing

I came a long way from having $72.00 in the bank (paycheck prisoner) to having a freedom fund that is worth 14 months of freedom (not a lot I know, but I'm getting there). 

As this freedom fund grows, I'll have to decide on a strategy for my compounding mechanism.

I'm a firm believer in the fact that the stock market is purely a compounding machine which requires an input of resources. To me, it is not the place to make money, but simply a place to grow & magnify whatever you throw into it

At the end of the day, you'll still need an active income source for a stock market strategy to work. 

Therefore, I'm not counting on stocks alone to path my route to freedom. My focus therefore, is skewed towards the active income side for these formative years. Some may argue that this is a "chicken and egg" problem. 

Doesn't matter. 

What matters is having a strategy and sticking to it.

So, back to the main point of this post, I have narrowed down my compounding mechanism to 2 choices: Dividend Growth Investing & Index Investing. 

I'm no financial expert and this is an over-simplistic view on the topic. Use your bullshit filter to assess whatever is written here.

Dividend Growth Investing

Keyword = Growth. 

It's not about generating dividends from this niche class of stocks, but generating growing dividends year after year. This increase in dividends (growth) alone is a good hedge against inflation.

To put it simply, we're not looking for just any stock that pays a fixed sum of dividends every year. What we're looking for is a stock that increases its dividends on a consistent basis. This way, whenever these stocks appreciate in price, the management will also increase dividends to maintain the same (or higher) yield.

In bad times, when the stock market plunges, dividend 'aristocrats' (yes, such stocks exist) still maintain the same dividend payout. 

Jason from DividendMantra is a good case study for this strategy.     

Criteria for Dividend-Growth Stocks: 
1) Dividends must increase every year, or demonstrate an upward trend
2) Dividends must be consistent (monthly, quarterly, bi-annually or annually)
3) Low to mid beta + sound fundamentals
4) Keep costs low
5) Don't focus on market timing. Buy on fundamentals (fair price) and hold for the long run. 
1) Dividend 'aristocrats' pay consistent dividends even during major financial crashes. This prevents you from selling in bad times if you happen to need the cash flow.
2) Constant stream of income
3) Growth in dividends is a good hedge against inflation
4) There is a definitive point signifying financial independence when monthly dividends = monthly expenses 
1) Requires an active approach 

What it really means:
During a market crash like the one we observed in 2008, you'll still get paid your dividends. If you lose your job during this same period, you'll still get paid your dividends. As statistics prove that the market will always rebound (if not soar) after a crash, a dividend growth strategy prevents you from having to sell your assets during a crash if you need the cash flow.

Financial independence is achieved when your monthly dividends cover your expenses, which makes it a popular strategy for those who are seeking early retirement.

Index Investing

I'm still in the midst of reading John Bogle's "The Little Book of Common Sense Investing" which lays out a very strong case for investing in a broad based index fund.

The past is certainly not an indicator of the future. But Bogle (creator of Vanguard funds) argues that if you know why the past happened the way it did, then it is the best indicator of future performance.

The case for index investing is based on a few tenets.

  1. The first being our inability to time the market. While active stock picking may generate great returns in certain years, it is sporadic. In the long run, a low cost index fund beats 70-80% of actively managed funds.

  2. The stock market is a zero sum game. Because someone has to sell before another can buy, when a person makes money in the market, someone loses money. So, why bother when you can buy the whole damn market? Instead of playing a game of roulettes, buy the whole damn casino.

  3. While actively managed funds may be equal/outperform the market in certain years by a few percentage points, costs have proven to negate the returns earned by actively managed funds.

  4. An index automatically rebalances your portfolio (again reducing the costs associated with manual rebalancing in the case of active stock management) 

  5. US Index Funds will always increase in the long run due to market efficiency & increased productivity, technological innovations which essentially translates to higher earnings by companies in the long run. You're buying all of that.

  6. Indexing is just common sense

Criteria for Index Investing: 
1) Broad-based (e.g. S&P 500, other Vanguard alternatives, etc.)
2) Low cost
3) Reinvest the dividends earned 
1) Investing on autopilot. Almost a no-brainer.
2) Relatively passive approach
3) The S&P 500 index average 10% gains per year since 1871. 10% average every year is certainly not a bad strategy for such a passive approach. 
1) When the market tanks by 30-40% like what we saw in 2008, it can be hard to keep calm and not sell
2) Discipline is required. Invest consistently, in good times and in bad times.
3) Benefits of index funds are always skewed towards US Indices. Certain foreign index funds do not rebound like US index funds. Furthermore, as a foreign investor, we are taxed 30% on dividends. Therefore, this strategy is not entirely universal.

What it really means:
All you have to do is to contribute systematically (every month/quarter) to a broad based index fund like Vanguard, sit back, relax and enjoy the ride.


So, dividend growth or index investing for me? 

As a foreign, non-US investor, a dividend growth strategy makes more sense as the principles are still applicable if I replicate the strategy in my local stock market. This way, I am also able to circumvent the 30% foreign withholding tax imposed on dividends if I were to buy into a US index like an S&P 500 tracker.

I've started with the dividend growth model and managed to lock in total earnings (capital gains + dividends) of 10.43% last year.

The issue here is I'm not sure if I can maintain that same 10% this year. 

"Two lumberjacks arguing about the best way to chop down a tree. "A sharp axe is the way to go." Says the first. The other disagrees, "You can't go wrong with a good saw." 
The axe club ridicules the saw group; whereas the saw crowd thinks the axe guys are backwards. At the end of the day, it doesn't matter. 
The tree is done for..." - anonymous

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  1. WCF,

    This is a pretty good comparison.

    I think that, in a lot of ways, the strategies are actually more similar than they are different. I've realized that the more I go on and invest. If you end up owning 50-100 high-quality dividend growth stocks, you essentially own an index of sorts anyway. The difference, however, being that you won't pay fees for the rest of your life and you won't have to worry about selling assets at an inopportune time.

    I always hear about the performance argument regarding active funds vs. passive index funds and how active funds lag due to management fees, but an individual investor won't be paying those management fees. Furthermore, those that point to individuals not outperforming the market I can only say two things:

    1. Growing dividend income that can pay for one's expenses and outperforming the market are not mutually exclusive. However, the latter isn't necessary to attain the former.

    2. What individuals are they talking about? I hear about how "people likely won't beat the market" (I don't really care either way, to be honest), but who are these "people"? Nobody has ever surveyed me or looked at my results.

    I think both are fine strategies. However, for reasons I've laid out in the past, I prefer dividend growth investing.

    Thanks for the comparison!

    Best regards.

    1. Jason, I think you brought up a fantastic point about the similarities between these 2 strategies and how we actually won't be affected by fees that much as an individual investor.

      I feel that there is always a lack of good literature when it comes to Dividend Growth Investing and most books tend to compare Index with 'Actively Managed Funds' and not individual investors like you and me.

      Thank goodness for the blogosphere.

      And I think your results do speak for themselves.

      Thanks for your much appreciated input.


  2. Good comparison.

    I'm still in the index fund boat but honestly, I feel like the most important part is getting the $$ into either type of account. Principal = power!

    1. Absolutely Chris, there is more than one way to skin a cat. As long as we achieve what we set out to achieve.

      And yea principal = power. That's why focusing on the active income side should not be neglected at all.

      High active income + low/optimised expenses = high magnitude investment returns.

  3. Sounds like you are making some solid progress with 14 months worth of living expenses in the bank.

    The great thing about personal finance is that there are so many roads that lead to freedom. No it is just finding the right one that fit your needs and goals.


    1. Hey GYFG, yes if I had not made an active effort to get my act together last year, I would still be living from paycheck to paycheck.

      Yup I agree that there are certainly many ways to freedom. We just gotta pick one and stick to it.

      I had a look at your Jan income report. Amazing.

      In all aspects.

  4. Came across your article when I was searching for exactly this comparison. I'm still on the fence! You laid out the arguments for both well. As Dividend Mantra stated above the two approaches are quite similar. The biggest difference is the time and effort involved to do the DGI method well and possibly still not getting the returns you want versus doing almost nothing with the index method. It seems like many who do the DGI method take it on as a hobby or almost a part-time job. I would love to hear your opinion after reading Mr. Collins' blog: Keep up the great work!

    1. Anon, thanks for dropping by...I've been on the DGI strategy for awhile now and I'm starting to think that it is a lot of work - although I must say that the constant dividends are quite rewarding.

      I'm starting to understand the allure of index investing, and they do spit out dividends as well. The correction in the stock market lately has sent some of my best stocks plunging and it is not a good feeling to have.

      The thing about these two strategies is that they are more similar than you think they are.