Wednesday, August 14, 2013

Dividend Investing Advantages and Disadvantages

Frugal Trader at Million Dollar Journey wrote a thoughtful post titled 5 Advantages of the Dividend Investing Strategy that caught my attention. He believes that both index investing and dividend investing are good strategies. I’m not sure if he intended his 5 advantages of dividend investing to be advantages when compared to index investing, but I’ll take them this way below.

Let’s examine each of these 5 advantages:

1. Produces a Passive Income Stream for Life, and with Raises!

Dividend stocks certainly produce passive income that tends to rise over time. However, indexing does the same thing. Dividend stocks produce bigger dividends, but indexes tend to produce bigger capital gains. So, I’d say that this advantage applies equally to both dividend investing and index investing.

2. Encourages Buying and Holding for the Long Term

I suspect that this is where dividend investing has an edge over index investing, at least for some investors. No matter how you invest, it’s important to stick with your plan rather than sell low when you get scared or buy high when you get overconfident. Some index investors have a tendency to change their asset allocations at the wrong times (selling low and buying high). The dividend investors I know seem to do well at sticking with their plans when the stock market gets volatile.

3. Helps Create a Market Bottom

I think this is really just a short-term concern. Over the long run, if a company’s earnings can’t support the dividend that it pays, then the company will eventually cut the dividend. For as long as investors believe the dividend won’t be cut, the stock price will be held up somewhat, but this can last only so long. Over the long run, stock prices are driven by company earnings whether the company pays a dividend or not.

4. Dividends are Tax Efficient

This depends on the investor. For the investor in the accumulation phase of life, growing capital gains in index ETFs in a taxable account is more tax efficient than dividend stocks because almost all taxes are deferred until the stock is sold. Over the long run, the dividend investor will pay more total taxes than the index investor will pay.

However, things change when the investor is actually living on the dividends. In this case, if the investor is index investing, he or she will be spending a combination of dividends and capital gains. Which approach is better depends on income level. For high incomes (in Ontario, over about $90,000 per year), capital gains taxes are lower than dividend taxes. When someone’s income is so low that they collect the GIS, capital gains are better than dividends as well. But for the bulk of Canadians who will be between these two extremes in retirement, dividends are more tax efficient.

5. Reduces Risk of Selling at Market Bottom for Capital

This is true, but it ignores another effect which is that companies who maintain their dividends at market bottom are pulling money out of the business during tough times. These are times when businesses are usually better off retaining earnings, either because earnings are down or because excess cash can be used to buy cheap assets. Pulling money out of a company in the form of dividends in a bad economy is damaging even if you can’t see a change in the number of shares you own.


Overall, both dividend investing and index investing have a lot to offer. Sticking with either for the long term is likely to work out well. Indexing has an edge in terms of diversification and taxes during investors’ accumulation phase. Dividend investing has an edge in sticking with the plan through tough times and with taxes during retirement. For myself, the advantages of indexing are more compelling, but your mileage may vary.


  1. I'm really impressed with the balanced articles I've seen recently on dividend investing versus index investing.

    It's lines like this, in particular, that stand out for me:

    "Overall, both dividend investing and index investing have a lot to offer. Sticking with either for the long term is likely to work out well."

    I think both camps can agree that the real enemy for investors are the high MER mutual funds that are pushed by commission-based advisors.

    Like FT, and Mark from My Own Advisor, I'm a fan of both strategies. While I prefer dividend growth stocks in my own portfolio, I'll happily recommend indexing (with e-series funds or broad market ETFs) to other investors.

    1. @Robb: I think the real issue is avoiding big mistakes. With index investing, a big mistake would be to sell stock ETFs after a market crash. With dividend investing, big mistakes would be to miss out on U.S. and foreign stocks or to own too few stocks.

  2. Hey Michael! The intention was not a comparison between the two, but I can see how it can be taken that way. I think that dividend investing is popular with the retire early crowd due to the advantages I listed. But I agree with you, I also index some of my portfolios and in terms of work/return, it's likely the best bet for most investors.

    1. @FT: I can certainly see why those with a desire to retire young would be looking for more income. Capital gains can be a good source of income as well, but dividend investors don't seem to like the psychology of selling shares, even if the share growth more than makes up for the sale.

  3. What about owning both - i.e. if my target equity allocation is 60%, why not own 30% in a cap weighted index ETF and 30% in a dividend ETF? I suppose the counter argument (at least in Canada) is that it could potentially lead to over exposure of certain sectors (i.e. financials as they both have high market cap and are steady dividend payers).

    1. @Trevor: I don't see a problem with using a mixed strategy as long as you have reasonable allocations to U.S. and foreign stocks and you don't change allocation percentages when you get fearful.

  4. Nice post Michael, I can't wait to discuss this again and again over many beers at CPFC13 :)

    Really though, always a fan of your logic and balanced approach.

    I have a post planned soon entitled "Why dividends matter" and my third point is all about the psychology of dividends. It's simply more tangible for investors; seeing dividends and less capital gains compared to few dividends/distributions and realizing/waiting for more capital gains with indexed products that likely helps us (dividend investors) stick with the plan more.

    Either that or we have smaller brains.

    Need to email you guys this week, re: golf.


  5. I'm not sure I see exactly how one gets an income stream from capital gains in a index ETF investing scenario. Do you mean you hope to sell just enough units to create an income stream, while the number of units stays about constant as the distributions of the companies in the ETF earns you more units? I guess it's possible you could avoid eating into your principal that way.

    It wouldn't have been possible a generation ago with the higher transaction fees to sell and the requirement to sell in board lots which would take too much money out of the game at one time.

    It's easier for me to visualize living off a dividend income stream while holding the same number of shares. That could just be because I've watched that in operation with older relatives. And of course most dividend stocks in recent years have made huge capital gains, so one could also sell some shares for the gains if need be.

    I think I'll continue with a lot of index funds and a few dividend payers. It's my un-patented wishy-washy investing strategy.

    1. @Bet Crooks: I mean focusing on the value of the portfolio (rather than number of units) and selling off gains as necessary to live on. It's certainly possible to sell a block large enough to live on for several months if that's what it takes to avoid unreasonable costs.