A very popular method of investing is to build a portfolio of individual stocks with a solid history of dividend payments. Dividend investors tend to believe that this approach will beat index investing, and index investors believe that dividend investors have sub-optimal portfolios.
Although dividend investing tends to be quite passive in the sense that it involves infrequent trading, it is at least a little bit active in the sense that dividend investors choose individual stocks. Any time you choose an active investing strategy, it makes sense to know how much your strategy is likely to underperform the market averages in the event that your strategy is little better than random.
So, if we begin with the premise that index investors are right and that dividend investors are likely to underperform, how much lower are their returns expected to be? To answer this question, I dug up an old paper by Meir Statman: How Many Stocks Make a Diversified Portfolio? In it he reprints a table of the number of stocks in a portfolio and its expected standard deviation from a book by Elton and Gruber. Here are a few lines from this table:
1 stock: 49.236%
10 stocks: 23.932%
20 stocks: 21.677%
All stocks: 19.158%
The volatility drag on compound returns is half the square of the standard deviation. So, here are the volatility drag numbers:
1 stock: 12.12%
10 stocks: 2.86%
20 stocks: 2.35%
All stocks: 1.84%
Compared to index investing where portfolios contain all stocks, smaller portfolios have the following excess volatility penalties on compound returns:
1 stock: 10.16%
10 stocks: 1.02%
20 stocks: 0.51%
All stocks: 0%
So, if a dividend investor owns 10 stocks and they are essentially randomly-selected, the investor is giving up 1.02% per year in returns. At 20 stocks, the penalty is only 0.51%.
Of course, dividend investors don’t believe that their stock choices are random. But even if they are wrong, a portfolio of 20 dividend-paying stocks from a wide range of different industries is only giving up about 0.5% per year compared to index investing (not counting taxes). Giving away returns is never a good idea, but many active investing approaches have higher expected losses to the index than just 0.5%.