5.5 Reasons Dividend Stocks Beat Target Date Mutual Funds

Target Date Mutual Funds May Not be on Target.

A fairly recent development in the investment world is the proliferation of target date mutual funds.  These vehicles have become popular in employer provided 401K programs as a means of helping (forcing?) employees to save for retirement.

The belief is that if an employee can invest a minimum of 3% of his or her paycheck simply, painlessly, and automatically, the person won’t object to being helped.  The employer provides a pool of mutual funds structured to optimize the return of the fund based upon a pre-selected investment horizon e.g., 15 years.  If you invest in a target date fund with a 15 year time horizon from the point of this writing, you would probably find yourself investing in a 2035 target date fund since the funds are usually presented in 5 year increments and 2035 is the closest date to a 15 year period.

You could invest in 5-year, 10-year, 20-year, or longer target date funds depending on how long you believe you’ll have to work until retirement, your offspring head off to college, or you have to pay for your daughter’s wedding, whichever comes first.  The target date of the fund determines how aggressively or conservatively your investments are managed. 

Funds with long time horizons are often invested more aggressively by holding large percentages of stock like small cap growth and emerging markets offerings which are normally more volatile than other investment options.  Funds with short time horizons are generally managed more conservatively holding large cap stocks, bonds, or even fair amounts of cash in order to protect investors from market downturns in the short run.

A target date fund is normally a fund of funds.  This means that all its holdings are those of other mutual funds aggregated to produce the appropriate target mix.  For instance, the Fidelity Freedom 2035 Fund is a mixture of at least 29 other funds – growth, index, small cap, bonds, money market, international, and more.  This target date fund has an expense ratio of .74%.  Several, if not all the underlying funds have expense ratios somewhere in the range of .01% to .06% of a percent per fund.  These expenses appear to roughly add up to the .74% ratio specified on the target date fund and eat into your return over the long run.  It should be noted I have a brokerage account at Fidelity and chose the example out of convenience since I don’t have the same visibility to funds from Schwab or Vanguard for instance.  However, other brokerages have target date funds organized in a similar manner to the example used here.

Now that you have a brief summary of target date mutual funds, I’ll explain why I believe a basket of solid dividend paying stocks is a superior investment to a target date mutual fund.

1. Management Fees:  If you purchase and hold individual dividend paying stocks you will pay no management or other expense fees.  Even though the fees associated with target date funds appear small, losing 1% per year over an investing lifetime can result in a noticeable difference.

2. Better Investment Choices: Dividend paying companies with long records of payments and / or dividend increases provide substantive proof of durability, reliability, and profitability.  The firms are publicly traded in which case you can find a plethora of information about the firm and its management team.  Conversely, target date funds are a mixed bag of underlying funds, some of which are new or nearly new.  They have little to no performance track record and frequently no management to be readily investigated.  In other words, investors are left in the dark and told to trust the fund provider.

3. Targets vs Target Dates:  Investments in solid, dividend paying stocks with a long history of payments offer you a snowball’s chance of determining a specific financial target at a specific date in the future and calculating what you’ll need to get there.  Target date funds promise they’re optimizing your returns over a specified period.  Unfortunately, these funds haven’t been around long enough to determine whether or not any of those promises hold water.  What they do seem to accomplish, however, is to ensure a bunch of funds unable to stand on their own merit are packaged in a target date fund to generate a few dollars in fees and potentially give a new MBA the chance to gain experience “managing” a fund. Think of a target date fund like cable TV.  You have to buy a bundle of channels, most of which you don’t like, watch, or know anything about, but have to pay a few bucks for in order to get those handful of channels you watch regularly.  The same principle applies with target date funds.

4. Investment Control: When selecting individual dividend paying stocks, you get to make the selections.  You aren’t arbitrarily required to buy a cable TV style package of stocks or mutual funds you don’t want in order to get the one or two you do.  As an individual stock holder, you also get to determine how long those investments are held.  When it comes to mutual funds, many have fairly high rates of investment turnover within the fund.  Think turnover greater than 50% annually.  That’s a lot of churn generating fees for someone other than you.

5. Real Compound Growth:  If you’ll recall my post on 7 Reasons Dividend Stocks Beat Real Estate Investing you’ll understand what I mean by real compound growth.  When dividend payments from individual stocks are automatically reinvested, you are issued additional shares of the firm.  Over time the percentage of the company you own as an investor actually grows, all other factors being equal.  In target date funds, any dividends paid to the underlying funds may result in changes to the NAV or Net Asset Value (valuation metric) for the fund and that’s it.  You don’t benefit from an increased ownership stake in anything.

As with other discussions, here are a few items to ponder.

0.5 Availability: In many 401K offerings, you aren’t given the chance to invest in individual stocks.  You may have no choices outside a basket of mutual funds.  In these situations, I’ve tried to stick with stock index funds like an Equity Index 500 or Russell 2000 index fund. 

These index funds offer greater visibility to the underlying holdings allowing me to see where my money’s going.  Also, a good equity index fund will have among the lowest management or administrative fee structures available.  Consequently, gains, if any, aren’t siphoned away by the transactions crowd over time at the same rate as target date funds.

Target date funds truly provide a “set and forget” offering.  However, I’d rather not set and forget my money then hope it’s where it needs to be when I’m ready for it.

The thoughts and opinions expressed here are those of the author, who is not a financial professional, and therefore should not be considered as investment advice.  This information is presented for education and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional. 

7 Reasons Dividend Stocks Beat Real Estate Investing (Part II)

This Old Investment.

In Part 1 of this series I covered the first three reasons dividend stocks beat real estate investing:

1) Low Initial Investment

2) No Financial Leverage

3) No Management Overhead

In this Part I’ll review reasons 4 through 7 on why dividend stocks are a superior investment to real estate.

4) Small Incremental Investments:  Like the initial investment in item #1 in Part 1, you can add to your dividend stock portfolio in dribs-n-drabs as your cash flow allows.  This makes it easier to compound your investments and / or diversify them if you wish.

Try adding a piece of rental real estate to your investment portfolio for 50 bucks a month.  The only way you can do it is with a dividend paying Real Estate Investment Trust (REIT) purchased just like any other stock.  ‘Nuff said.

5) Positive cash flow:  All the time (almost).  When you buy dividend paying stocks, particularly solid stocks, you can pretty well count on getting positive cash flow every month for stocks paying monthly or quarterly for stocks paying every three months.  If the dividend gets cut, your cash flow goes to zero, but not below that point.

With real estate you can easily and regularly experience negative cash flow.  If you get into a fix-n-flip, you’re cash flow will be negative from the time you buy the property to the point you sell it – and possibly thereafter if you have to sell during a market dip.

In the rental market, you can regularly count on having negative cash flow several months out of every 12 once you factor in the rent / re-rent phases of ownership.  Should you have any repairs along the way, you might have several months each year of negative cash flow or even an entire year, despite having a renter on prem, if the repair has a hefty price tag.  Of course, if you have the coin to purchase a rental for all cash, it’s easier to experience positive cash flow nearly every month.  If you could do that, though, you wouldn’t be reading this post.

6) Real Compound Growth:  When you buy a dividend paying stock and let the dividends reinvest, you get additional shares of stock.  These shares pay future dividends which buy more stock which pays more dividends and so forth.  You may start with a few shares (pieces of a company) at the age of 23 and wind up with thousands of shares (pieces of a company) at retirement through compounding alone i.e., without adding anything out of pocket.  This is what I refer to as real compound growth.

With investment real estate you get compound growth as well – on paper.  For instance, if you buy a $100,000 property that appreciates at 2% per year, you’ll have a property valued at $102,000 at the end of the first year and $104,040 at the end of the second year.  However, you’ll still have only 1 property, not several and certainly not thousands by the time you retire.

In both cases, div stock and real estate, you can see value appreciation (or depreciation), but in only one will you see actual pieces added to your monopoly board through compounding.

7) Risk Diversification:  Because you can purchase dividend paying stock in small increments, relative to real estate, it’s much easier to diversify away risk.  With stock, you can spread your money, however little or much, across multiple firms.  As a result of this, you significantly limit the probability of a catastrophic event causing your entire investment to go to zero.

Real estate normally requires putting all your money into one property.  Because you can’t easily diversify across multiple properties, let alone multiple properties in different regions or geographies, you can’t reduce the possibility of a catastrophic event driving your investment to zero.  What’s more, a single catastrophic event with a real estate investment can plunge you into large, negative financial territory if you use leverage (debt) which you almost certainly will in order to invest in the first place. 

I’ve flogged this horse long enough.  I can’t recommend real estate investing to anyone and certainly can’t do so when dividend stocks are available.  If I could, I’d recommend annuities while I’m at it, but in 9 Reasons Dividend Stocks Beat Annuities, you’ll learn why I can’t do that, either.  Apparently, I’ve become an old curmudgeon.  Until next time, happy dividend investing! 

The thoughts and opinions expressed here are those of the author, who is not a financial professional, and therefore should not be considered as investment advice.  This information is presented for education and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional. 

7 Reasons Dividend Stocks Beat Real Estate Investing (Part I)

Real estate investing is touted as a great way to make money, particularly if you’re using someone else’s cash.  During rising real estate markets in certain areas, it’s possible to make money this way.  However, it’s hard to time the bottom of a market just before it booms and even more difficult to determine the top of a market just before it goes bust.  If you miss the timing on the front side you won’t see many gains and if you miss the timing on the back side, you can easily lose your backside.

This truism is relevant for the fix-n-flip crowd, but also holds water for buy and holders planning to rent a property until the market rebounds.  I was one of those buy and holders.  It didn’t work. 

This old investment.

I owned one or two rental properties at a time continuously for about 13 years.  One property I held for 11 years cost me $55,000 during that period.  That money, had I invested it in high quality dividend paying stocks, would have eventually paid the college bills for at least one of my offspring – maybe two.  Consequently, I know of what I speak when I write there are 7 Reasons Dividend Stocks Beat Real Estate Investing. 

1) Low Initial Investment.  You can buy dividend paying stock for tens of dollars to get started e.g, ARCC is at $16 - $17 with a dividend of about 9%.  Unless you go back in time to the early 2000s when “no doc” loans were popular you can’t get into a piece of real estate for anything less than several thousand dollars.  According to Zillow.com, the average home price in the United States, as of this writing, is $218,000. If you qualify for a VA loan, you may be granted the loan with no money down, but you’ll still pay a loan origination fee of 2.15% or $4,687.  And just so you know, you won’t get a VA loan for rental property.  Furthermore, you can’t go back in time to 2003 and get a no documentation loan.  A “no doc” loan meant all you had to do was tell a lender you made $150,000 annually.  They’d take your word for it and give you an enormous loan based upon your statement.  Is it any wonder we had a housing crash? 

By the way, any conventional loan is likely to require you put 10% down ($21,800 for our average home), then pay Personal Mortgage Insurance (PMI) on top of your monthly loan payment.  Otherwise, you’ll need 20% down or $43,600.  If the lender suspects you’re buying a rental property, the institution will require 25% down ($54,500) since it’s effectively a commercial loan.  How many people have that kind of coin to get into real estate investing?  But what if you could finance the whole thing, 100% of it, with someone else’s money?  That’s called leverage.

2) Financial Leverage:  Investopedia loosely defines leverage as the use of borrowed funds to increase the potential returns of an investment.  Note the word “potential” in front of “returns” and keep it in mind as you read.  When you borrow money for a real estate investment, there is a possibility you can use those borrowed funds to significantly increase the return on your down payment.  To be overly simplistic, let’s say you put $10,000 down and borrow $90,000 to buy a $100,000 property.  If the property appreciates in value to $110,000 you will have “earned” $10,000 on your original $10,000 investment, less any interest payments you made in between the purchase and sale.  As a result, the simple return on your money would be 100%.  Not bad.  Then again, nothing in real estate is simple.  Funny thing about leverage, though.  It works both ways.  If the value of the house falls to $90,000 and you have to sell, you lose 100% of your down payment since funds from the sale cover only the loan amount you owe.  If the value of the house falls to $50,000, you lose your $10,000 investment and still owe another $40,000.  Now you’re upside-down.  That’s being polite about it.  You’ll use more colorful language with your bowling buddies if this happens to you.  I’m sure of it.  After a $55,000 bath, my language rivaled a rainbow.

If you buy dividend stocks, however, leverage won’t be involved – unless you’re stupid.  Don’t ever buy stock using borrowed money.  If you want to do that, then do real estate and go big.  May as well get a fun story out of your destitution, right?

3) No management overhead (headaches):  Dividend paying stocks require very little management work on your part.  You do your research, you purchase your stock, and you monitor for catastrophic events.  Otherwise, you watch your dividends reinvest and your initial purchase compound.  Pretty straight forward.

Real estate investing confers brain damage of the first order whether you’re a fix-n-flipper or a buy-and-holder.  Beyond the mind numbing purchase process common to both cases, which is far more onerous than buying stock and carries a much higher transaction fee, the fix-n-flipper has to find a trustworthy, reliable, competent general contractor at best or sound handy-man at worst to do the fix up.  This assumes, of course, the investor isn’t going to act as his or her own construction agent which is often equivalent to representing yourself in a court of law. 

Once the contractor is on the hook, you’ll probably have to micromanage the contractor to keep him on schedule and close to budget.  You’ll deal with all kinds of direct management headaches while doing this and the project still won’t complete on time or budget in most cases.  This of course costs you in materials and labor overruns plus the additional carrying costs you’ll incur because you can’t put the house on the market as soon as you’d like.  The time value of money is real, folks. 

Then, like the buy-n-holder, you’ll have to navigate the aggravating process of selling your investment trinket, covering your 6% transaction fee, and hoping the market doesn’t tank before you unload it.  Otherwise, you may become a rental landlord whether you want to or not.

As a rental owner, you’ll enjoy the process of finding and vetting renters, including all the no-shows who will fill your schedule to look at your place, then bail out with no warning.  Once a renter is installed, you’ll be surprised at the number of calls you may get for things like water leaks, electrical problems, strange smells, broken appliances, and various other “defects”.  These calls normally don’t occur during optimal hours.  Instead they’ll happen during family vacations when you’re out of town, on birthdays, during holidays, the middle of the night, or when emergencies such as a family member’s hospitalization occurs.  Then you’ll have to drop everything and find someone to address the problem or take care of it yourself.

And if you don’t have a financially responsible renter, you’ll get to chase them down to collect the rent they owe you in addition to the fun above.

After your renter moves out, you’ll experience all the property repair, replacement, clean-up, and preparation activity needed to start the new renter search.  This happens about every 12 months unless your renter ditches you with no warning in which case you’ll conduct this process more often.  This scenario is not uncommon.

The best part of the whole real estate investing bonanza is that as the travel distance from your rental increases the aforementioned time and effort seems to increase exponentially as you endure the extra drive time to and from your real estate funplex.

An alternative to this party is a property management company which requires plenty of management overhead on your part, but not as much as if you do it all yourself.  The trade-off is that instead of paying with your own time, you’ll pay fairly high management fees each month (like an annuity!) turning your positive cash flow property, if it is, into a cash negative money sink instead. 

Although this trauma isn’t guaranteed, it’s highly probable.  I lived it for over a decade and don’t recommend it.  Dividend paying stocks are far less troublesome from a management perspective.  Someone else gets paid handsomely to take care of this management joy on your behalf and you?  You get to collect the dividends.

The thoughts and opinions expressed here are those of the author, who is not a financial professional, and therefore should not be considered as investment advice.  This information is presented for education and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional. 

9 Reasons Dividend Stocks Beat Annuities

Gambling.  Annuities.  Same thing.

Annuity Warning

When you gamble, you’re putting money into a game playing against the casino, using “house rules”, and hoping you come out ahead.  As most people know, the odds favor the house.  This doesn’t mean everyone always loses, but over the long run, far more people lose than win making the house the big winner in the end.

Annuities are pretty much the same thing.  In this case, insurance companies and other financial institutions are the equivalent of the casino and you’re putting your money into a game with odds heavily favoring those folks – not you.

Why would anyone gamble like this?  Mostly because they’ve been “sold” an annuity not understanding the purpose of an annuity or how it works.

An annuity is a contract between you and the insurance company that says the insurance company will pay you a certain stream of income over a future period of time.  In exchange, you must give that insurance company a lump sum of money OR agree to make a series of payments up front during what’s referred to as an accumulation phase.  In other words, give me your money and I guarantee you’ll get (most) of it back in the future. 

Put in such stark terms, it’s reasonable to believe many buyers wouldn’t pull the trigger on an annuity purchase, but they do because they don’t understand what’s happening.  The annuity contracts require you to pay some form of commission up front, baked into the deal so you can’t see it of course, AND then hang additional management fees on top of that, for the life of the annuity.  These commissions and management fees seriously degrade your “investment”, which isn't likely to be high quality to begin with, but hey, it’s supposed to be a “guaranteed” income stream over time, right?

There are multiple flavors of annuities e.g., fixed, variable, hybrid, life certain, etc.  However, they are all designed specifically to favor the seller in aggregate.  If not, nobody would sell them, right?

Given this background, here are 9 reasons I believe dividend stocks beat annuities.

1)    Commissions:  If you buy a stock with a solid history of dividend payments, you’ll do so for only a few dollars at a time through most brokerages.  Let’s say you buy $10,000 of a div stock through Fidelity.  You’ll pay anywhere from $5 - $10 to do so.  However, if you contract for an annuity of $10,000 with an insurance company, you could pay commissions in the 3-7% range or $300 - $700.  The cost to get into the annuity is 30x to 140x times higher than it is to get into the stock.

2)    Management Fees:  Once you buy a dividend stock, you pay no management fees for the privilege of owning it.  On the contrary, the annuity is likely to charge you a relatively substantial fee each year to “own” the annuity.  Management fees are often on par with those of managed mutual funds.  If managed mutual funds charge 1% to 3% per year, that's about what you can expect from an annuity.

3)    Surrender Fees: If you buy a dividend stock today and discover in six months that you need the money, you can sell the stock and pay the commission which is only a few bucks through most brokerages plus taxes on any gains (if there are any).  However, if you buy an annuity today and discover in six months that you need the money, you’ll pay a hefty surrender fee.  For instance, assume your annuity had a 7-year surrender period and you withdrew your money in six months.  Your surrender fee is likely to be 7% of your annuity ($700 on a $10,000 annuity).  If you need your money out in three years your surrender fee drops to 4% of your principle corresponding with four years left in the surrender period.  This $400 still a hefty chunk.  Under these conditions you won’t avoid the surrender fee until you’ve passed the seven-year mark on the annuity.  What's worse, some annuities have surrender periods up to 10 years.

4)    Risk: Annuities are mostly sold by insurance companies.  Insurance companies can go out of business like any other firm.  If you have $10,000 to invest and put it all into an annuity you’ve put all your eggs into a single insurance company basket.  While it’s possible to spread your annuity funds among a few insurance carriers, it’s much easier and more economical to spread your $10,000 investment across several dividend aristocrats or champions, at lower cost and with less complexity.  Spreading your investment funds across several investments diversifies away much of your investment risk while putting all your money into an annuity through one insurance carrier doesn’t.  We may explore the probability behind risk diversification in a later post.

5)    Complexity:  It’s easier to understand what AT&T, General Motors, IBM, or Microsoft do as businesses, but it's tough to understand the nuances of a variable annuity vs a life certain product, particularly when offered by different carriers much less the underlying investment structure.  The clarity and ease of understanding that comes with investing in a dividend stalwart vs an opaque annuity makes it easier to determine where your money’s going, how you can get it back, and when.  The rules of dividend stock investment are more user friendly than the rules of annuity selection.  Considering the costs associated with annuities, who needs the complexity on top of it?

6)    Cash Flow: Annuities are sold as vehicles providing a “guaranteed” stream of income over a period of time.  In exchange they take a large bite out of the principle in commissions and fees, then lock up your money through high surrender fees for prolonged periods.  Dividend stocks also offer a stream of income (not guaranteed however) in exchange for which you don’t get gouged with high fees or be forced to lock up your money.  While the annuity stream may provide a larger periodic payment than the dividend stock, it does so by returning a portion of your original principle along with a small investment return.  If you want the same effect with your dividend stocks you can get it by taking the dividend stream while selling a small portion of your underlying portfolio and doing so without any of the large annuity fees.

7)    Incremental Investments:  Annuities require either a large, lump sum payment up front or substantial monthly payments during an accumulation period.  This means you have to start out with a lot of cash or a healthy stream of disposable income.  If you don’t have either of these, then an annuity is out of the question.  However, you can start saving for your future with much smaller investments in total or even smaller monthly contributions e.g., $25 when investing in high quality dividend stocks.  Furthermore, you make those investments on your schedule, not on an insurance company’s.  This allows you to take smaller, cautious steps when starting to save for your future.

8)    Fiduciary Requirements: Up until 2016 or so, agents selling annuities did not have to act with fiduciary responsibility in selling an annuity.  In other words, they were allowed to sell customers whatever would pay the highest commission to the agent irrespective of whether or not the product was in the buyer’s best interest.  When the Department of Labor (DOL) enacted fiduciary requirements, annuity sales began to plummet since agents had to take responsibility for the products they sold and they didn't want to be responsible for a bad apple.  Annuity News even documents the decline.  Unfortunately, the Fifth Circuit Court has overturned that DOL ruling to allow agents to once more sell whatever pays them the greatest commission (see notes above about annuity commissions).  However, the registered investment advisor through whom you are most likely to make your dividend stock purchases is required by the Securities and Exchange Commission to act with fiduciary responsibility when selling stocks.

9)    Investment Visibility:  When you buy an annuity, you’re buying a pig-in-a-poke, blue sky, swamp land in the Everglades, a bridge to nowhere, or who knows what else.  You don’t really get to see or understand the underlying “investments” the annuity provider is putting your money into.  If you buy dividend stocks, however, you can readily see how and what they’re doing.  There is a universe of news, stock, advisory, and regulatory filings you can dig through to gain visibility to your dividend investment.  No such galaxy of resources is available to you for an annuity.  Unless you enjoy losing coins in a couch, it’s nearly always better to see where your money’s going and what it’s doing when it gets there.

If you’ve been keeping score on that original 10,000 dollar investment you put into an annuity, you lost $300 to $700 in up-front commissions, plus another $100 - $300 in fees the first year (plus a similar amount every year thereafter).  This means you’re behind the investment curve by $400 - $1,000 just for signing up.  And if you have an emergency in the first year requiring you to gain access to that money, you’ll lost another $700 - $1000. 

In a worst case scenario, you’re down $2,000 with an annuity before the year’s over.  Granted, that should be the extent of it unless the insurance carrier goes out of business.  Then you lose the lot.  On the other hand, if you put $10,000 into dividend stocks spread across 3 to 5 flavors you’re out about 50 bucks in brokerage fees and that’s it.  It’s possible you could lose the entire $10,000 in a catastrophic market meltdown, but if all 5 of your dividend champions went to zero in a single year, we’ve probably all got a lot more to worry about than market losses.  We’ll be living in mud huts wondering if we’ll ever see the sun again.  

The probability of taking substantial loses with an annuity is, from my perspective, much higher than the probability of suffering a significant setback with a handful of solid dividend payers.  You may have a different take and that’s ok, but at least there's an alternative to consider.

In the next post, I’ll explore the reasons Dividend Stocks Beat Real Estate Investments.

The thoughts and opinions expressed here are those of the author, who is not a financial professional, and therefore should not be considered as investment advice.  This information is presented for education and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.