Investing For The Long Term: Dividend Growth Stocks Or S&P 500?

| About: SPDR S&P (SPY)

What's the best way to invest for the first 35 years of your life? This question was the subject of a fascinating discussion among the comments on an article about the dividend investing and asset allocation:

MBKelly75: Starting young has amazing results. All of my children and all of my grandchildren got their first stocks on their 4th birthday. My first (and so far only) great grandchild was not even born yet and owned some MCD. By the time my kids hit 35 years of age they had been compounding [dividends] for over 3 decades and adding to it and compounding every year of those makes a really, really does...

Norman Tweed: mbkelly75--You have been an inspiration to me and I am following in your footsteps with my grandchildren.

Hedged In: Norman, one thing to think about is how many stocks survive after 30 or 35 years. It's great to hear that David Fish picked MCD, but what if he'd picked one of the *many* companies that shrunk into oblivion or went bankrupt? It would be interesting to look at the S&P 500 from 35 years ago and count how many of the stocks no longer exist. For that reason, you might be a lot safer buying SPY or even VWO for them. Unless you want them to be actively managing a portfolio and realizing capital gains...

Norman Tweed: Hedged In--I was there in 1955 buying dividend stocks. As I worked through the 1970s Great Inflation, I saw a small startup company, Vanguard, come out with a mutual fund--Index 500 which became VFINX. I thought it would be great as a retirement vehicle. I bought PG, D, T on the outside market and went with the Index in the 401k plan that the company produced from it's thrift plan. During the Great Bull Market 1982-2000, VFINX did great! PG, D, T just loafed along reinvesting the dividends. Then came the ax in 2000. All of a sudden, I was on the street with "the package". Guess what! The tech bubble burst and VFINX went south. I had bought ABT, JNJ, and MRK in the late 1990s on the outside for possible retirement--I thought 2005. I have watched SPY, VFINX and all other index funds become cyclical since that time. PG, D, T, ABT, JNJ just keep loafing along reinvesting the dividends, and going up. I even bought VWO in 2007, because I thought I needed foreign exposure. I only lost $5K on VWO, but a lot more on VFINX. Mutual funds hold all the bad ones as well as the select. If you study the market for long enough, you find the dividend growth stocks that continuously raise their dividends--those are the ones to buy. I was burned badly on financial stocks, which cut their dividends. However, diversification has made my retirement work.

Norman Tweed's final comment touches on a crucial issue for indexers: problems with the market cap weighted S&P 500 index (SPY and IVV). It's not a coincidence that between 1995 and 2007 he beat the S&P 500 by holding non-tech stocks. This is because there were tremendous problems with the index. When you purchased an S&P 500 fund in 1995, the tech bubble was already inflating. S&P itself aggravated the problem over the next few years by adding a disproportionate number of tech stocks to the index, and dropping non-tech stocks. By 2000 the tech bubble was fully inflated, and after it burst the index didn't recover for a decade.

These problems with the index showed up in simple metrics. The tech sector accounted for a massively higher percentage of the S&P 500 by market cap than it had historically, and the P/E ratio for the entire index went stratospheric as the largest cap stocks like AOL, YHOO, DELL, CSCO, INTC and MSFT traded at massive multiples.

But despite the problems with the S&P 500, not all investors who used index funds had poor performance from 1995 to 2007:

  • Those who were managing a portfolio of broad diversified asset classes (such as domestic equities, foreign equities, bonds and REITs) would have been rebalanced out of domestic equities consistently from 1995 to 2000.
  • Those who were rebalancing between sectors would have done even better - not only would they have avoided the tech bubble, but also the bubble in financials that followed in 2003-7 and the subsequent crash that trashed the financial dividend stocks Norman owned.
  • Those who followed simple valuation rules (eg. based on P/E ratios) cut their exposure to the S&P 500 or entirely moved to the side lines. I remember Byron Wein at Morgan Stanley saying in 1999 that valuations were ridiculous and investors should get out.
  • Those who used an equal weighted approach to the index also did well over the entire decade, as they have subsequently using the equal weighted ETF (NYSEARCA:RSP).

But isn't the whole point of indexing to avoid having to make judgments about valuation? No. Index investors avoid making valuation judgments about individual stocks, but must account for valuation in their asset allocation decisions. Just buying the S&P 500 isn't enough. You need to buy a few asset classes and rebalance, or account for valuation in some other way.

Dividend growth investing also takes valuation into account. It's a methodology based on straightforward valuation and growth rules. Dividend yield is a value metric, very similar to a P/E ratio if you also take account of the dividend payout ratio. And looking for companies that consistently raise their dividends is a growth metric. By combining the two, dividend growth investing can be seen as a subset of GARP investing (growth at a reasonable price). If you look at the historical data on how dividend growth investing has performed, it works well - but not as well as some other value and GARP strategies.

Dividend growth investing as a sole strategy for an entire portfolio has other risks too. Many dividend growth investors only purchase domestic equities, neglecting proper asset allocation. And as advocated by many of the dividend growth investors on Seeking Alpha, it requires individuals to pick stocks and know when to sell them, which most individual investors don't succeed in particularly well. (Simple rules for selling, like "Sell when a company cuts its dividend" could be disastrous. Think of what happens with stocks that crash and then cut their dividend - you might be selling at the bottom.)

And I suspect that some dividend growth investors don't hold enough stocks to diversify their risk.

I'm not writing this to attack dividend growth investing or to try to dissuade those who are happily using it. On the contrary, dividend growth investing provides an investing and saving-for-retirement framework that is extremely successful for many people for practical and psychological reasons which aren't given adequate weight in the academic literature. (I don't want to say more about this now, as I'm hoping to write another article on that topic.)

But as a strategy, picking a small handful of stocks for your grandchildren, and planning to hold them for 30 years greatly raises the risk of loss and under-performance. The probability of picking companies that will thrive for 30 years is not high.

As a result, a much safer strategy for saving for the first 35 years of your or your grandchildren's life is to buy three or four low cost equity ETFs and rebalance once a year or when the allocations get too far from target.

For example, you could choose three ETFs covering large cap value (SPYV or IWD), small cap value (SLYV or IWN), and emerging markets (NYSEARCA:VWO). Your grandchildren, who don't need income from dividends along the way, would almost certainly end up with a larger nest egg that way than with a handful of large cap US dividend stocks.

So the answer to the question "Investing For The Long Term: Dividend Growth Stocks Or S&P 500?" is actually "neither". Instead, buy a few low cost ETFs and rebalance. It's not hard.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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