Combining Index Investing And Dividend Investing In Your Portfolio

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Includes: AFL, GLD, NOBL, SPY, TLT, VIG
by: Sure Dividend

I recently wrote an article comparing dividend investing to index investing.

Spoiler alert: Here's the conclusion reached in that article:

"Dividend investing and index investing aren't really at odds with each other. Both work well for different types of investors.

Having an investment plan and sticking with that plan are far more important than agonizing over dividend investing or index investing."

There are many investors who aren't just dividend investors, and they aren't just index investors; they practice both.

This article takes a look at how to combine index investing and dividend investing in your portfolio.

Brief Overview of Index & Dividend Investing

When I refer to "dividend investing" in this article, I'm referring to investing in individual dividend stocks, not in dividend ETFs.

Index investing is investing in low cost passively managed index funds. Good examples are the SPDR S&P 500 ETF (NYSEARCA:SPY) and iShares 20+ Year T-Bond ETF (NYSEARCA:TLT), among many others. Dividend ETFs are considered a part of index investing for the purpose of this article.

With that out of the way, this article will look at how to get the best from both index investing and dividend investing by combining them in one portfolio.

Note: I personally invest entirely in individual stocks. All of the recommendations in the Sure Dividend Newsletter are for individual stocks, not ETFs. This article is for investors looking to combine both individual stocks and index funds, not strict adherents of either respective discipline in isolation. With that said, I believe the ideas in this article present a compelling (at least to me) way to combine index investing with investing in individual stocks.

Index Investing & Dividend Investing: The Best of Both Worlds

What index investing does best is provide wide diversification at an incredibly low cost.

There are a wide variety of dividend investors. I believe investing in high quality businesses with shareholder friendly managements trading at fair or better prices is an excellent way to compound wealth.

So in summary, index investors practice wide diversification while dividend investors focus on their best individual business ideas.

How can you combine these two separate ideas?

By using index investing as a "holding pattern" while you wait for the best possible opportunities to come up for investing in individual stocks.

An Index Portfolio for All Markets Part 1: Equities

We will start by building an index portfolio for all markets. This portfolio should have the following characteristics:

  1. Low cost
  2. Well diversified
  3. Simplicity is preferred
  4. Performs well in all market environments

By focusing on passive index funds, we will easily satisfy requirement 1.

Being "well diversified" does not mean investing only in equities. It means going beyond them.

The less correlated 2 assets are, the greater the diversification gains. The following funds have fairly high (all above 0.5 over long periods of time) correlations to each other:

  • United States equities
  • Emerging market equities
  • International equities
  • Domestic real estate
  • International real estate

Instead of trying to "thin slice" to find the perfect balance between a wide variety of closely correlated assets, we will use one ETF that will provide both income and equity returns.

The Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) is a good choice. It has an expense ratio of just 0.09% and tracks the performance of the Dividend Achievers Index. Dividend Achievers are stocks with 10+ consecutive years of dividend increases. There are currently 274 Dividend Achievers.

The performance of VIG (including dividends) versus the SPY is shown below:

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Source: Data from Yahoo! Finance from 5/2/2006 through 7/18/2016. 5/2/2006 is the first date of performance history for VIG

As you can see, VIG has offered similar returns to SPY, but with a bit better drawdown protection.

Note: There is a tremendous amount of variety in equity and equity like index funds. The Dividend Aristocrats ETF (NYSEARCA:NOBL) might be a better choice than VIG for dividend investors. Other investors may want to try a mix of a United States ETF like SPY and an emerging market ETF like VWO together. There are nearly endless combinations one can use for equity ETF exposure. Adding different equity and quasi-equity ETFs will give diminishing diversification benefit gains. For the sake of simplicity, only (VIG) is used in this article.

An Index Portfolio for All Markets Part 2: Other Assets

As mentioned above, most asset classes have a fairly high correlation with equities.

There are 2 that have either a 0 (or nearly zero) or negative correlations with equities (and with each other):

  • Gold
  • Government Bonds

Note: Palladium, platinum, and emerging market bonds have some potential as well for additional uncorrelated asset classes. Presumably other highly developed economy government bonds (think Germany) would offer a similar safety profile as U.S. Government bonds.

The SPDR Gold Shares ETF (NYSEARCA:GLD) is a good proxy for Gold. It has an expense ratio of just 0.40% per year.

For government bonds we want a fund with a maturity as far into the future as possible. This gives us greater exposure to interest rates per dollar invested. You get more 'bang for your buck', which is important in an unlevered portfolio.

The iShares 20+ Year Treasury Bond ETF (TLT) is a good choice. It has an expense ratio of just 0.15% per year.

The performance of VIG, TLT, and GLD is compared with (SPY) in the image below:

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Source: Data from Yahoo Finance from 5/2/2006 through 7/18/2016. 5/2/2006 is the first date of performance history for VIG

Performance around the Great Recession is circled in red. As you can see, both TLT and GLD provided diversification when it mattered most -- when equities were in freefall.

The correlation matrix for each of these ETFs is shown below over the timeframe mentioned above:

Click to enlarge

As you can see, GLD, TLT, and an equity index fund(s) of your choice makes for a portfolio with assets that have low or negative correlation with one another.

An Index Portfolio for All Markets Part 3: Combining The Asset Classes

We will build our portfolio with:

  • VIG
  • TLT
  • GLD

But in what amounts?

Equal weighting (33% - 33% - 33%) the portfolio would mean putting more 'risk' into GLD. That's because GLD has a higher stock price standard deviation than either VIG or TLT.

Note: The asset classes outlined above closely match the Permanent Portfolio. You can see my thoughts about modifying the Permanent Portfolio with a dividend ETF here.

The stock price standard deviations for each of these 3 ETFs over the time period discussed earlier is shown below:

  • VIG's annualized standard deviation is 17.9%
  • TLT's annualized standard deviation is 14.9%
  • GLD's annualized standard deviation is 20.2%

We will take a simple risk parity approach and invest to have equal volatility from each asset.

To find the weights, do the following:

  1. Calculate the annualized standard deviation for each ETF
  2. Find the reciprocal (1 / std. dev.) for each ETF
  3. Sum these numbers
  4. Divide each reciprocal by the sum

Taking this approach, we get the following weights:

  • 32% for VIG
  • 39% for TLT
  • 29% for GLD

To make things a little simpler (what's a few percentage points among friendly asset classes?) let's smooth this out to:

  • 30% VIG
  • 40% TLT
  • 30% GLD

The image below shows performance for this portfolio over the previously announced time frame compared to SPY (portfolio is rebalanced annually).

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Note: Yes, the weights involve look back bias. Take the performance above as a proof of concept. It would be close to what one would achieve if they calculated the weights before the fact instead of after. Relative asset class price standard deviation is fairly constant over long periods of time.

The table below shows the portfolio's performance and risk statistics versus SPY:

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I would expect SPY to outperform this portfolio over long periods of time, but only by 1 or 2 percentage points a year.

What stands out about the portfolio we built is its low maximum drawdown and low price standard deviation. The portfolio takes a low-risk approach while providing satisfactory returns.

You can take advantage of this portfolio's low drawdowns and volatility by being an opportunist when stock prices fall.

The next section of this article covers how to add individual dividend stocks (or any type of individual stock you prefer, really) to this portfolio.

Before we move on, I'd like to point out that this is only one idea for a low-risk index fund portfolio. Several other ideas are below. The point is to find a portfolio likely to provide fairly stable turns regardless of market conditions.

Adding Individual Dividend Stocks

After your core index portfolio is built, it's time to…

Practice Do Nothing Investing.

That means you sit and wait for a great opportunity to come up.

The stock market is made up of individual stocks. High quality businesses do occasionally go on sale even when the market is overvalued on a historical basis.

With that said, there are certainly more (and better) opportunities around when the market is in free fall.

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I don't think it's wise to wait for the market to become undervalued on a long-term historical basis before ever purchasing individual stocks. That's because the market can stay overvalued for years - or even possibly decades.

Today's low interest rate environment makes a return to price-to-earnings ratios of 15 or lower for the S&P 500 unlikely.

Instead, wait for an overreaction. Take advantage of other people's fear. The point at which people start getting panicky is difficult to say with precision.

For the purpose of this article, let's say it's when the S&P 500 hits drawdowns of 20% or more. The last time this happened was August through September of 2011.

Take a look at a quick Google News search for "S&P 500" during this time period:

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Now compare that with the same search, but using the timeframe of the last month

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In the 2011 picture, we see a lot of pessimism. The 2016 picture shows more of a mood of cautious optimism.

Were there high-quality dividend growth stocks on sale in 2011? Absolutely. One example is Aflac (NYSE:AFL). Aflac is a Dividend Aristocrat and the global leader by market share in cancer insurance. You can see the company's stock price in the image below:

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Source: Google Finance

Note the steep sell-off in the company's stock during August and September of 2011.

How Much to Add (and What to Sell)

Knowing when to add individual stocks is only half the battle.

The other part is knowing how much to add when opportunities present themselves.

Like with most aspects of investing, I believe a systematic approach that is laid out beforehand is best.

Here are the rules I propose:

  • Buy up to 5% of your portfolio's value in 1 stock
  • Move funds from index portfolio to individual stock portfolio based on market drawdown
  • Only act when market drawdown hits 20% or more
  • Move 20% of index portfolio to your 4 'best idea' stocks (5% each) when 20% drawdown is hit
  • Add another if 25% drawdown is hit, and another if 30% drawdown is hit, and so on

This approach would mean an investor would move 90% of their index portfolio to individual stocks during the very worst depths of the Great Depression, and 55% to individual stocks during the very worst of the Great Recession.

You should know what will trigger a sell of your individual stocks beforehand as well. When individual stocks are sold, the funds should be added back to the index portfolio to gain a decent return while waiting for the next big opportunity.

New funds introduced into the portfolio should go to the index allocation as well to compound while waiting for the next opportunity to buy individual stocks at a deep discount.

The index side of the portfolio is meant to grow wealth regardless of market conditions, and preserve that wealth when large drawdowns in the stock market occur.

When large drawdowns do occur, one should be opportunistic and pick up high quality businesses at bargain prices -- whatever businesses you deem to be sufficiently high quality that are the hardest hit.

The index portfolio should be viewed as a whole. Do not liquidate just the VIG portion of the portfolio when selling to make room for individual stocks. This will disrupt the balance of the index portfolio.

I believe this approach would combine the focus of dividend investing with the wide diversification benefits of index investing.

You get to benefit from diversification gains while also keeping an eye out for great opportunities.