Monkey Throwing Darts

Is a Portfolio of Individual Dividend-Paying Stocks Better Than an Index Portfolio?

Monkey Throwing Darts

Question: Rather than investing in a portfolio of index funds, would I not be better off by simply assembling a collection of well-known individual stocks that have a history of increasing their dividends? What would the IFA risk and return chart look like for the 25 best current dividend paying stocks over 5, 10, 15, 20 years?

Answer: There is an enormous problem with assembling a portfolio of individual stocks based on a characteristic (such as increasing dividends) that you see today and then assuming that any historical alpha (return above a risk-appropriate benchmark) would persist into the future. Namely, you are making the assumption that you would have chosen the exact same stocks at the beginning of the period. Not only would some of today’s stocks not been chosen say twenty years ago based on the dividend criteria, but there would have been other stocks that you would have chosen that did not deliver positive alpha, to put it mildly. We can think about this as an example of survivorship bias, which makes the average historical returns of active managers look higher than what they truly are because the ones that fail are excluded.

At this point, it may help to look at some specific examples. Twenty years ago, a blue chip portfolio of dividend paying stocks likely would have included General Motors, and if you recall from the 2009 bankruptcy, GM’s common shareholders were completely wiped out. Investors who reinvested their dividends through GM’s DRIP got a minus 100% (total loss) return on their investment. Seven years ago, General Electric was widely considered to be among the “best” dividend-paying stocks, but in 2009, it slashed its dividend by 67% after its share price dropped by 56% in 2008. Thus, it would not be included in a portfolio that would be assembled today. From the opposite prospective, Apple is now considered a solid dividend-paying stock, and its very high historical return would substantially boost the historical return of a portfolio that includes it. However, twenty years ago, Apple was paying no dividend, so it would not have been included in a model portfolio.

The example of Apple highlights a common misconception among investors concerning dividends. While many investors believe that they will get a higher return because their companies will pay them dividends, the reality is that companies pay dividends when they are profitable, and it is their profitability that drives their returns. In other words, these investors are putting the cart before the horse. They are also missing out on companies that will have high returns with little or no dividend. Investors who own these companies (or rather index funds that own these companies) can create their own dividends by selling shares, as discussed in the video below:

If we really wanted to get an accurate assessment of how a stock picking strategy focused on dividend-paying stocks has fared, we would need a low-cost mutual fund that has consistently applied this strategy for at least twenty years. Fortunately, we have such a fund, the Vanguard Dividend Growth Fund (VDIGX), which currently owns 52 well-known companies that pay a good dividend and have a history of increasing it. Its expense ratio is only 0.29%, and it has a low turnover of 11%. Thus, we have chosen this fund as a proxy for a dividend-paying stock picking strategy. The charts below show how this fund fared for 5, 10, 15, and 20 years.

Compared to globally diversified portfolios of index funds tilted towards small cap and value stocks (the IFA Index Portfolios), this fund held its own for the five and ten year periods. Unfortunately, these periods are too short to draw any definitive conclusions from. When we go the twenty year period, VDIGX underperformed an IFA Index Portfolio of the same risk by about 1% per year. While this may not seem like much, the impact on the growth of wealth over such a long period can be substantial. Specifically, while $1 million would have grown to $4.3 million with VDIGX, it would have grown to $5.2 million with Index Portfolio 72. Please note that we are not claiming that the twenty year period is statistically significant.

When we dig a little bit deeper into the holdings of VDIGX, we see that it is overweight in consumer staples and pharmaceuticals. While there is nothing wrong with owning those companies, investors should expect that there will be time periods when being overweight in those sectors will cause them to lag the overall market.

To summarize, while owning a portfolio of dividend-paying stocks can provide the psychological satisfaction of an income that is expected to increase over time, it is not an optimal way to capture the long-term returns offered by various risk dimensions of the market.