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.