Wednesday, September 5, 2012

Should You Invest In Dividend Stocks or ETFs?

Hello citizens of Dividend Nation.  My pen name is Teacher Man™ and I am co-owner of the blog My University Money.  I also write for several other personal finance blogs, and have recently decided to try my hand at this whole eBook thing.  Before I get into trying to convince an audience full of dividend believers that I believe I have a better approach, I should probably get one thing straight.  As long as you are out of debt, saving, investing for the long-term, and determining what your best exposure to equities is (taking into account your time horizon and risk tolerance), then you will be absolutely fine with either method.  I have read the Dividend Ninja’s articles since I saw him in MoneySense magazine a few months ago, and I learn something new whenever I visit his site.  I think he has some great advice on dividend investing.  I just believe 100% that the average investor is much better off investing in ETFs than they are trying to pick stocks of any kind, be they dividend, growth, or otherwise.

I should also take the opportunity to give a big shout out to DN for his willingness to help me promote mynew *FREE* eBook on ETF investing.  When I approached him with the idea of promoting our book on this site I qualified it with the statement that it probably wasn’t a good fit because of the focus on dividend investing.  He responded that he thought the book offered value to his readers, so I hope that I fulfill that promise!

 ETFs or Stocks?

Dividend investors and ETF investors often share several things in common.  Both groups are strong advocates for buy-and-hold investing, they also believe in systemic additions to their positions over the long-term.  Both DN and myself agree that trying to pick stocks and trade them on a daily basis is a quick path to financial ruin.  From what I have seen, ETF investors (or “couch potato investors” as we are commonly known as) and dividend investors are both conscious of trying to minimize investing costs and use the power of compounding returns to build their investment portfolio.  What I’m trying to say is that if you are actually debating between ETF investing and dividend investing, then you are already far ahead of the vast majority of investors out there.  That being said, I honestly believe that the vast majority of investors would be better off investing with ETFs than trying to buy their own stocks, no matter what strategy they choose.  The reason for this is simply that humans are just inherently terrible at picking stocks and sticking with them!

If I were to convince myself that I was capable of picking stocks, I would almost certainly be a dividend-heavy investor.  I would try and pick stable stocks, and find advantageous entry points, much like DN or several of the authors that often comment on this site.  The problem is that I don’t believe that I am capable of picking stocks and more importantly, I’m quite content not trying.  Now you may ask, “If this guy doesn’t even know enough to evaluate specific stocks, why the heck should I listen to his investing advice?  There are tons of smart people on the Internet that tell me what stocks to pick all the time and give me compelling reasons to do so.”  Here is my rationale, several studies have proven that over the long-term the average investor will lose out to the market average.  Most notably an extensive Dalbar study from 1990-2010 showed that while the S&P 500 had an average return of 9.1%, the average American stock investor only achieved a 3.8% return.  The numbers on professional money managers that get paid big bucks to pick stocks for mutual funds show that they often fair just as bad as these “amateur” stock pickers.  I am fine with the relatively high average returns on equities as an asset class.  I’ve made my peace that I won’t ever “beat the street,” and that by admitting this I’m going to do better than roughly 98%+ of the investors in the market.

 Capital Growth or Dividends?

Now, the Dividend Ninja and I have had a short email debate arguing the benefits of dividend investing versus those of ETF investing.  He (like many dividend investors) believes that the huge advantage dividend stocks have is that they generate a solid income, and this income can be compounded over time (ideally through ultra-efficient DRIP programs).  Many dividend investors believe that capital growth is irrelevant to their strategy as a whole.  I don’t follow this line of thinking. Unless you need income as an investor (ie. you are retired and depending on your investment returns as a source of income) I don’t understand why reinvesting dividend income is superior to capital growth?  My sole goal when I invest is to grow my nest egg as quickly as possible, regardless of if I am using compounding capital growth, or reinvesting dividends.
If you are like me and don’t care where your returns come from in your portfolio, as long as they are as large as possible, then I think there is a strong argument that dividend-only investors are actually missing out on the returns of an attractive part of the stock market.  Almost all dividend-payers are by nature mature companies. If they are channeling their profits back to shareholders in the form of dividends, then they are obviously investing a smaller percentage of their profits into growing the company.  Almost all stocks that dividend investors invest in are considered “large market capitalization stocks” which means they are big companies.  Over the long-term, it has been generally proven that small-cap stocks will outperform large-cap stocks, even after dividends are calculated in.  The only problem with that statistic is that individually, small-cap stocks are extremely volatile, and to try and pick specific winners carries a lot of risk.  This is where ETF investing comes to the rescue.  By choosing an ETF that tracks the Russell 2000 index, or a similar model, you can get the average growth rate of those “risky” small-cap stocks.  The best part is that it isn’t like you have to choose between dividends and capital growth when you choose ETFs.  Investing in ETFs doesn’t mean that your dividends simply disappear, they just get absorbed into the value of the fund and consequently increase your principle.


As I get older, and am looking to generate a little more income from my equities exposure, I might begin picking some of these nice-looking dividend stocks that DN, and other sites such as The Dividend Guy, and My Own Advisor espouse.  There has been plenty of people achieve success with the dividend model in the past, and I’m sure that the model will continue to reward its advocates; but the fact is that if you’re looking for the MOST stellar returns with the LEAST maintenance then you should see if ETF investing is right for you.  As a side note, there is no rule that the strategies cannot be combined for a “best of both worlds” approach, I know of a few really smart bloggers that use this approach, and have built up very enviable portfolios!
You may now return to your regularly scheduled income-oriented, DRIP-loving programming ;) Thanks for your time and attention!

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