Reader Mailbag: Dividend Investing vs Index Investing

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Hi Kyle,

I'm loving the mailbag feature you started. Here's my questions I'm hoping you can answer: Do you know anything about dividend investing or any resources to share on dividend investing? It seems like all personal finance bloggers are pushing index investing. I understand indexing and am following that strategy right now. The only “competing” or comparable strategy I see around is investing in stocks with strong dividends. I'm curious how this compares to indexing as an investment strategy, but don't know where to start to get information on it.

I guess I'm wondering if it's a “safe” long term strategy like index investing? It must require more time and research compared to just picking index funds. Like I said, I don't really know much about it besides seeing it mentioned in some articles (and having a family who likes to only buy stocks that give dividends) so I was looking for an introduction.

-Rebecca

Hi Rebecca,

Dividend Investing vs Index InvestingI think I speak for all index investors when I say, “Hey, I got nothing against dividends, I love dividends!”

My index ETFs all have very nice little dividend perks (the cap-weighted average dividend of all the stocks included in the index).  The thing is I don’t really care if a stock produces dividends or not as long as it is awesome.  How do I know a stock or company is awesome you might ask?  I know that it is awesome because it is my index – the 60 biggest companies in Canada, 4,000+ biggest companies in the USA, or 6,000+ biggest companies in the world (check out this article for more information the ETFs I’m referring to).  By making a blanket statement like, “I only invest in companies that pay dividends” (Kevin O’Leary has made this attitude sort of famous) you are leaving some pretty massive winners off the table.  Warren Buffett – who many consider the greatest investor of all time – doesn’t pay dividends out to holders of his company’s (Berkshire Hathaway) shares.  Apple didn’t pay dividends during all of the years it saw explosive growth either.

Apple would have been a stock that growth investors loved.  Growth investors tend to be on the opposite end of the spectrum from dividend investors.  The idea is that if a company is paying a dividend, usually it is a fairly stable, mature company that has a proven record of profits.  Growth investors would argue that the real money is in identifying stocks that are quickly growing and have competitive advantages.  These types of companies are often small companies that are taking large risks and many pay only small dividends or none at all.

It all comes back to the fact that there are essentially two ways a stock can make you money.  It can go up in value (whether through higher profits, stock buybacks, or anything else).  This is called a capital gain.  The other way is through dividends.  Some people will argue for one form of making money over the other depending on tax situations and other various criteria, but since pretty much all of my investing will take place in registered accounts, I’m not too worried about it all.  Ultimately, I find debating the whole growth vs dividend vs value investing models to be a lot of abstract razzle dazzle that usually just results in a typical “paralysis by analysis” situation.  This is where the true value of index investing lies: in its simplicity! (Now even more simple due to the super easy to use robo advisor options available and the fact that Questrade allows you to purchase ETFs for $0!.)

I don’t know who is right and who is wrong to be honest with you.  I do know that I’ve read a lot of articles by growth investors, dividends investors, and value investors (the group I think has the best theory for what it’s worth).  All of these authors seem to be smart and educated, and with their official-looking statistics they are all great advocates for their investing strategies.

Here’s what else I know: if I let all of these super smart investors with competing strategies fight it all out and do all kinds of fancy math calculation with super computers and generally apply concepts that are beyond me to the stock market – then simply take the average of what those guys all create – I’m going to be in good shape.  If I take that average in a super tax-efficient way, while minimizing all of my investment costs – then I’m really laughing (and probably making more than almost any of the above investors).

Here is my common sense-fueled line of thinking when it comes to picking an “investing style” or strategy:

1) There is so much money on the line in the stock market and so many smart people trying to get it, is there any way that a strategy that works today won’t be immediately copied by thousands of people tomorrow and consequently lose its overall advantage?

2) Am I smart enough to come up with said strategy or be one of the first people to fully understand this new strategy and apply it to my own portfolio?

I’m pretty certain at this point that the answer is no on both accounts.  If your answer is also no, then picking index investing in the cheapest possible way is the only logical path forward.

Dividend investors and index investors have many things in common; we’re close investing cousins on the overall spectrum of investing strategies in my opinion.  For example both approaches advocate for long-term buy-and-hold thinking.  If you invest using either principle you’re going to end up with a portfolio of mostly large, stable companies (cap-weighted macro indexes tend to be filled mostly with huge dividend-paying companies anyway).

Dividend investors will usually defend their strategy using three main selling points:

1) Using dividend-based formulas and dividend-growth statistics, investors can identify stocks that will outperform the market average (pick better than normal stocks).

2) The constant stream of dividends can be a tax efficient form of income.

3) Dividends are a great way to encourage yourself to stay in the market when stocks take a big downturn.  That mental reinforcement can be a really big help when everyone else is selling off.

These ideas have merits, but I’ll address them anyway:

1) If dividend investors really are that great at picking stocks, then soon all the smart guys who have access to way more information than me will do it that way and the market will level off again.

2) This is true, but as long as stocks are in your registered accounts (TFSA, RRSP, RESP) then the advantage is pretty much nill.  If your registered accounts are full (yay for you!) then this would certainly be an advantage worth exploring – especially for Canadian dividend-payers.

3) Very true.  This is why I look at my index’s dividends and smile.  That’s all the mental reassurance I need since I’m comfortable with the basic math I’ve read that shows it is extremely hard to pick stocks no matter what strategy you choose.

We have lots of dividend articles here on the site since our staff writer “Young” is a big advocate of getting those periodic cheques.  You can also see a great article here about a recent convert to our “dark side” of index investing from dividend investing.

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Kyle is a high school humanities teacher by day, and freelance personal finance author by night. He has been published in academic journals, and has also co-authored the book "More Money for Beer and Textbooks". In his free time Kyle likes to limp up and down a basketball court and pretend to be a tough guy in a boxing ring.

5 Comments

  1. Robb Engen on May 27, 2015 at 10:14 am

    Thanks for the mention, Kyle. I think dividend investing (particularly dividend growth investing) is a fine strategy, but you have to stay extremely dedicated to the approach, which means practising extreme patience. Of course, that means fighting every behavioural bias you can imagine to keep you from tinkering with your portfolio too much.

    In the end, I just didn’t have the time or discipline to stick with it and so switching to indexing was a natural choice. I unsubscribed from all those individual stock alerts and honestly barely look at my portfolio now.



  2. Kyle on May 27, 2015 at 6:59 pm

    Welcome to the dark side Robb. I look at my portfolio four times a year. Maybe twenty minutes total.



  3. My Own Advisor on May 28, 2015 at 5:25 pm

    Dividend investing, at least from a Canadian perspective, does not have to be a science. Own most of the companies in XIU and index the rest via VTI. Done!

    I also re-adjust my portfolio about 2 hours per year. Easy 🙂

    Dividend paying stocks make great sense non-registered, when registered accounts are full of course!

    Mark



  4. Toan on May 28, 2015 at 9:12 pm

    The way I see it, dividend-paying stocks are for those who need income coming in.

    It tends to require more time and effort spent for dividend investing to be worth it.

    Your time is better spent working on advancing your career and maybe learning something new to bring in extra income.

    I love index-investing for this reason.

    Cheers!



  5. Kyle on May 28, 2015 at 9:57 pm

    Definitely Mark. I made sure to include that caveat in there. Canadian dividend stocks are exactly where I would go if my registered accounts were full. (I got a lot of work to do before that’s a worry!)



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