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 (WMT) job as a greeter out of necessity. The thing is that no one 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. I’m going to focus on four of them: