Index investing and dividend investing both have cult-like followings. And, like many cults, both groups have a tendency to believe they have a monopoly on the truth.
While the two strategies emphasize many of the same ideas, such as maintaining a long-term viewpoint and keeping buying and selling to a minimum, dividend investors and index investors are akin to oil and water. They just don’t mix well.
Index investors believe dividend investors are merely one category of stock-pickers. They see dividend investing as an active investment strategy and since there is no reliable method of identifying which active investment strategy will outperform the market in the years ahead, indexers shun the dividend guys.
For their part, dividend investors can point to a lot of evidence that suggests selecting strong companies with a track record for growing dividends is a market-beating strategy. The dividend fanciers also like the fact that dividend yields automatically increase as a stock’s price drops, giving dividend stocks a built-in counterbalance when markets turn down.
There are entire books dedicated to each strategy. For many investors trying to decide which path to follow, it comes down to which book they read first.
From a purely theoretical perspective, indexing wins. Assume you have two identical companies – one that pays a dividend and one that doesn’t. The overall gain before taxes on both would be identical. At least in theory, the company paying the dividend would have a share price that would be lower by the amount of the dividend. So dividend investors wind up no further ahead.
But don’t dividends put cash in your pocket? Sure – but investors desiring cash flow could just sell shares in non-dividend paying stocks to mimic the dividends they’re missing. (This assumes a sufficiently large enough portfolio that transaction costs are minimal.)
Another argument put forward for dividend investing is based on the notion that the cash generated by large, profitable businesses can be better put to use elsewhere by the investors who receive it via dividends. This, too, is misleading. Younger businesses may need to hold on to their cash to grow faster. Older companies that have to make a strategic shift or acquisition may also have better uses for their cash than paying it out as a dividend.
Dividends can actually be dangerous. Because a decent dividend yield is so highly regarded by shareholders, companies may feel pressured to maintain payouts, even if the cash could be better utilized within the business.
All that being said, there are long periods in which dividend strategies beat the market. But it is worth noting that dividend strategies have a tendency to tilt toward bargain-priced value stocks, and that value stocks have been shown to exhibit both higher risks and higher rewards, which reconciles this apparent disparity. (For those interested in more information on this, grab a big cup of coffee and look up the Fama-French three factor model of stock market returns.)
So what’s the verdict? While indexing wins in theory, it's not by a landslide. In theory, theory and practice are the same. In practice, they are not.
After speaking with many investors, I’m convinced that conviction is a stronger determinant of long-term portfolio success than the choice between indexing and dividend investing. A well-diversified dividend portfolio and a well-diversified couch-potato portfolio are both solid long-term strategies that share several commendable characteristics.
The real risk lies in abandoning either strategy prematurely. Pick one and stick with it.