Dividend investors and indexers often disagree strongly on the relative merits of their investing strategies. Recently, the Dividend Growth Investor argued that homemade dividends produced by selling some stock are not as good as real dividends. However, we can easily show that the core of the disagreement comes down to whether or not dividend stocks have an expectation of higher total returns.
For the purposes of this discussion, let’s compare an indexed portfolio of stocks that pay a 2% dividend to a dividend stock portfolio that pays an average of 4% dividends, both in tax-advantaged accounts. For the investor who wishes to live on 4% of his portfolio each year, his choices are to go with the indexed portfolio and sell 2%1 of his shares each year, or go with the dividend portfolio and live off the 4% dividend.
Dividend Growth Investor argues that “when someone sells a portion of their portfolio, they end up with less [sic] shares.” However, if the two portfolios get the same total return, then the shares in the dividend portfolio will be worth 2% less than the index portfolio shares are worth just prior to the sale of 2% of the index shares. After this sale, the two portfolios will have the same portfolio value.
Dividend Growth Investor goes on to argue that “Sometimes share prices fall or stay flat for extended periods of time, which could spell trouble for these [index] investors.” The implication here is that the index portfolio is shrinking, but the dividend stock portfolio is not. However, this can only be true if the dividend stocks are getting a higher total return. Otherwise, if index stocks are flat, dividend stocks are suffering a 2% capital loss each year.
I could go on, but all of the arguments come down to the same thing: will carefully-selected dividend stocks get higher total returns than the index or not? If the dividend stocks outperform, then the dividend investors are right; otherwise the indexers are right. Unfortunately for the dividend investors, the apparent evidence for long-term dividend stock outperformance has significant survivorship bias. If the indexers are right, then they have the advantage of a slight boost to returns that comes from better diversification.
1 The actual percentages are slightly off these approximate figures due to compounding effects, but I’ll use the round numbers to avoid muddying the waters.