Why Dividend Growth Investing Is Better Than Index Investing (2024)

Whether dividend growth or index investing is better is controversial and the subject of many debates. There are diehards in both camps. Dividend growth investing has gained in popularity over the past several years. Today, many blogs and newsletters exist focused on this type of investing.

On the other hand, index investing, or ‘indexing,’ has existed for much longer. The concept can be traced to John Bogle, the founder of Vanguard mutual funds. Diehard enthusiasts of index investing are referred to asBogleheads, their resource website. Their focus is theBogleheads 3 Fund Portfolio. Index investing was arguably profound at one time, but the idea is now mainstream.

I think that dividend growth investing is better thanindex investing. That said, I do both. My focus and this site are about dividend growth investing. Nevertheless, I use index investing for my retirement accounts for multiple reasons. In fact, for most people, investing in index funds is the simplest and best way to go for retirement accounts.

However, dividend growth investing has some advantages compared to index investing.

What is Dividend Growth Investing?

Dividend growth investing is investing in stocks that pay a growing dividend over time.Dividend yieldalso matters, but high dividend yield is not the focus; it is dividend growth. The dividends are reinvested during the early stages of investing or the accumulation stage.

An investor generally should own between 20 and 30 stocks for diversification. However, the exact number range for diversification varies based on the research. Only some of the stocks should be in the same sector for diversification. A person diversifies because some stocks perform well at any given time while others perform negatively. Diversification reduces the correlation between stocks and reduces the risk of losses. A tool to check the correlation of equity holdings isStock Rover*. It can analyze daily return correlation.

Most dividend growth investors start with a handful offoundational stocksand add to them with time. The growing dividends increase the revinvested income stream. After retirement, the dividend stream becomes income for monthly expenses. It’s quite simple.

What Kind of Stocks Pay a Growing Dividend?

Dividend growth stocks are categorized by the consecutive number of years that a company pays a growing dividend. Companies that have done so for 50+ years are called Dividend Kings. Companies that have paid a growing dividend for 25+ years are known as Dividends Champions. Those that have increased the dividend for 10 – 24 years are called Dividend Contenders. Lastly, companies that have raised dividends for 5 – 9 years are known as Dividend Challengers. Look at the variousdividend growth stocks listsfor U.S. and international stocks.

It is no small matter to get to the 50+ year mark. There were only 44 companies on the list at the start of 2024. This is out of nearly 6,000 companies listed on U.S. stock exchanges (NASDAQ and NYSE). This is a pretty select group. Many companies struggle to make it to 25 years due to recessions and, in some cases, poor management decisions, as seen in the Dividend Cuts and Suspensions list. At the latest update, there were 700+ companies on the list. This is not a tiny number and represents over ~10% of companies that pay dividends.

What is Index Investing?

Index investing is the concept of investing in a group of passive low-cost index funds that track benchmark indices. This could be traditional index mutual funds, or it could be exchange-traded funds (ETFs). It would help if you had a target allocation as an index investor. A common one is 60% stocks and 40% bonds, but the allocation could be whatever you choose. Other examples are theWarren Buffett Two-Fund Portfolioand theCoffeehouse Portfolio. The ideal index investing allocation is also intensely debated. We will leave that discussion for another time.

A person is pretty much done once they set an allocation and monthly investment amount into a handful of index funds. In index investing, diversification comes from choosing different asset classes or types of index funds—for instance, stocks with varying market capitalizations or in various sectors. Regarding bonds, they could be funds that focus on U.S. Treasuries, corporate bonds, municipal bonds, etc.

Once per year, an investor must rebalance their portfolio to adhere to the target allocation. Again, much like dividend growth investing, it’s reasonably straightforward.

Let’s examine three reasons why dividend growth investing is better than index investing.

Fees for Investing in Dividend Growth Stocks Are Lower Than Index Funds

There is now no commission on stock trades at many brokerages. This is a significant advantage as there are essentially no costs for accumulating dividend growth stocks. The expense ratio is zero if a person is a do-it-yourself (DIY) investor focused on dividend growth stocks. Additionally, reinvesting dividends is generally free and automatic, especially forcompanies with a dividend reinvestment plan.

This has not always been the case. Even 20+ years ago, a single trade cost was very high at $20 or more. This meant that buying $1,000 of stock had a 2% fee, buying $5,000 had a 0.4% fee, and buying $10,000 had a 0.2% fee. In the past, this was higher than the expense ratio of most index funds.

Today, a fund like Vanguard’s Total Stock Market Index (VTSMX) has an annual expense ratio of 0.14%. This is very low. Still, not having any commission on a stock transaction is even lower. Further, a mutual fund’s expense ratio is paid annually. The percentages seem small, but let’s fast forward to retirement. Let’s say you have $500,000 in VTSMX. The annual fee is $750. This money is not going to you.

More Control

A dividend growth investor has more control than an investor in index funds. As a DIY investor buying individual stocks, you have more power over which stocks to buy and at what price. An index investor relies on the underlying index. This index will change with time. For instance, the S&P 500 Index, the tracking index for many of thelargest mutual funds by assets, changes periodically. Hence, an index investor does not control which stocks they own.

Let’s compare using the Vanguard Dividend Appreciation ETF (VIG). The top 5 stocks in the fund are Microsoft (MSFT), Apple (AAPL), JPMorgan Chase (JPM), Broadcom (AVGO), and UnitedHealth Group (UNH). These are all excellent stocks, but you may not want to own one or more for various reasons. For instance, some people may want to avoid holding bank stocks.

In addition, VIG has about 315 stocks in its portfolio. Some of these stocks have a short history of raising dividends. Hence, do you really want to own them? I don’t because I prefer equities with at least five years of dividend growth.

Further, as a DIY dividend growth investor, you retain voting rights. Of course, a person must make sure they vote annually. An investor in index funds generally does not exercise voting rights—instead, the fund manager or firm votes for you.

Don’t Have to Sell Assets

As a dividend growth investor, you do not have to sell assets once after retirement. Instead, a personlives off the dividend incomestream they have accumulated. In addition, this dividend income stream is relatively predictable and grows each year due to increasing dividend payout. Even in a severe market downturn, the cash flow from dividends is less likely to be affected.

That said, dividends are not immune to cuts or suspensions. We maintained a running list of dividend cuts and suspensions during the COVID-19 pandemic. So, we understand this can happen. However, even after dividends are cut or suspended, they tend to be restored and grow over time. This happened to many real estate investment trusts (REITs) and banks after the Great Recession from 2008 to 2009.

This contrasts the underlying principle of investing in index funds, where retirees sell 4% of their assets annually. This percentage is a widely acknowledged rule of thumb as the safe withdrawal rate. Consequently, retirees sell off 4% of their index funds yearly to pay an annual income. This can work. But the problem, as many experienced during the dot-com crash (2000 – 2002) and Great Recession, is that they could be selling assets into a declining market. Their nest egg declined; the 4% rule means the annual income is lower.

Final Thoughts on Why Dividend Growth Investing is Better

Both strategies are widely accepted and demonstrated to work. However, some people feel dividend growth is better than index investing and vice-versa. The main common principle for both is leveraging the power of compounding over time.

However, the differences are where people debate the pros and cons. If time is a consideration, one should choose index investing because dividend growth requires a more active approach. That said, it is much easier than day trading. However, if minimal expenses, retaining assets, and consistent income streams are prioritized, then the dividend growth strategy is preferred.

Disclosure: Long MSFT, V, and UNH.

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