You Don't Use A Benchmark?! It's About Opportunity Cost

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 |  Includes: SPY
by: Celestial Hedge

Article Overview:

Last week, Dividend Mantra wrote an article about dividend investing and why he doesn't compare his portfolio to the S&P 500. It was a very well written article, and, as of this writing, had 172 comments from interested and engaged readers.

When I read it however, I found myself disagreeing with many of the points he made. I will go through the assumptions he makes in his article and state my point of view. I would love to read your comments about both articles, and which point of view you take.

Dividend Mantra's Situation:

Dividend Mantra states that he is a dividend growth investor, as stocks with increasing dividends make up a cornerstone of his investment strategy. I will begin by saying that at my current age and risk profile, I do not follow this strategy, but realize that it can be very effective and useful for the right investors. He goes on to say he also does a little bit of value investing, which is the investment strategy I attempt to follow.

Disagreement:

I first disagree with his article when he says the "ability to one day live completely off of the dividend income [his] portfolio generates has nothing to do with the performance of the S&P 500, or [his] portfolio's performance against it." My reaction is to immediately say that yes, it most definitely does!

The discrepancy between our views lies in opportunity cost.

People compare their portfolios to the S&P 500 because their portfolios differ from the S&P 500, though they could be investing in ETFs like (NYSEARCA:SPY) that produce S&P 500 returns. There is opportunity cost to everything we do. If you have 2 hours of free time, you could go see a movie or stay home to watch a basketball game on TV, but you cannot do both. By doing one, you give up the utility you would receive from doing the other; you choose to do whichever one gives you the most utility. Stocks are no different. If you have $100 to allocate to stocks, you still have opportunity cost in what you buy. If you buy $100 worth of AT&T (NYSE:T) stock, you cannot also buy $100 worth of The Container Store (NYSE:TCS) stock, and vice versa. Since Dividend mantra invested all his money in dividend stocks, he cannot invest any in SPY, but he could have if he wanted to.

I hope that makes sense.

No matter what your goals are for your investments (DM, being financially independent at 40 is a GREAT goal and one I wish to achieve), the total returns of your portfolio will dictate whether you successfully reach your goals in that time frame. Let's assume, as Dividend Mantra says in his article, he earns $5,000 per year through dividends from a 6-figure portfolio. This means he has (at most) a 5% return on his investments. The long-run stock market average return (depending on whom you ask) is around 7-9%. He could be invested completely in SPY, earning these returns, but he chooses to follow a safer investment strategy with lower returns, and there's nothing wrong with that.

While I understand dividend growth investing and even have some DGI stocks in my portfolio, the strategy doesn't preclude tracking SPY. For an investor looking for lower-than-average risk with lower-than-average returns, an entire portfolio of DGI stocks is completely acceptable. However, DM, saying that the S&P 500 is an "arbitrary benchmark," and asking what anyone's ability "to purchase food or pay for rent" has to do with how the S&P 500 performs seems misguided and very focused on the short term.

DM states he invests in stocks with a lower beta, as he is worried about his liquidity and being able to pay for living expenses, experiencing less "dramatic ups and downs." Many investors hold 3-6 months of income in liquid assets such as bank accounts, short-term bonds, or CDs for expenses and emergencies/sudden unemployment. Simultaneously, one could also immediately invest into an ETF whatever part of their paycheck is unnecessary to achieve their savings goal. In some ways, these strategies could be considered even more liquid, as the cash reserve in a bank account will always be there, and does not rely on the timing of dividend payouts.

In conclusion, opportunity cost is something we take into account every time we make a decision. My opportunity cost for writing this article was perhaps going out with friends to bars, but I thought this would prove to be a wiser long-term investment.

Dividend Mantra, I have great respect for you, especially considering that you save 50% of your net income every month, drive a beat-up car to save on expenses, and hold no finance degrees yet take such a smart approach to investing. However, I want you to realize this opportunity cost way of thinking so you can (perhaps) retire even earlier than you had planned! It would certainly take dealing with more market ups and downs. If you prefer less risk, then stay in DGIs and keep doing your thing. But you should track the S&P 500, because we all have opportunity costs, all the time. Your definition of success shouldn't simply be meeting a goal, because if there's a way to complete your goal ahead of time, you didn't perform efficiently.

Thank you DM for allowing me to debate you, and I look forward to hearing everyone's thoughts on the topic.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.