5.5 Reasons Dividend Payers Beat Index Mutual Funds & ETFs

Index?  Mutual?  Dividend CCC!

Over the past couple months I’ve covered a host of reasons I think investing in strong dividend paying companies is better than parking money in real estate, precious metals and collectibles, non-dividend stocks, annuities, and target date mutual funds.  Therefore, I thought I’d tackle the reasons dividend stock investing is superior to index mutual funds or ETFs.  I’ve had a lot of coffee today and it’s probably a good thing, so here we go.

1) Compound growth is more reliable with dividend stocks than it is with index mutual funds and ETFs in general.  When individually held dividend stocks pay out their dividends, those dividends turn directly into additional shares of the company, assuming you’re enrolled in a Dividend Reinvestment Plan (DRIP).  Many, but not all, index funds and ETFs will retain dividends paid, increasing the Net Asset Value (NAV) rather than turning those dividends into additional shares of the fund for you.  I hold a couple such index funds in a 529 plan for my kids and a 401k so I’m well aware of this fact.  I don’t have much choice in either case.  Otherwise, neither would be in my portfolio.  NAV can fluctuate up and down given the market movement of the stocks it holds, irrespective of dividend payments.  In comparison, directly held dividend payers don’t subtract shares from your bucket unless you sell them.

2) Management fees erode your returns.  When participating in the DRIPs of dividend paying companies, or automatically reinvesting dividends from stock held in your brokerage, you don’t suffer the penalty of management fees.  The same cannot be said of index funds or ETFs.  This is particularly true if you’ve blundered into a managed index or ETF in which case your fees can be as high as a half-percent per year.  That may not sound like much, but once your portfolio reaches $100,000, you’ll lose $500 every year.  Those losses add quickly, particularly when you factor in the power of compound growth foregone.

3) Visibility and manageability of your holdings is much better with a select portfolio of dividend payers.  An index fund or ETF attempts to hold the same companies, in the same proportion, as found in the index it tracks.  Consequently you could own thousands of firms, most of which you’ll care little about – if you know about them at all.  To find out what you own in an index fund you have to sort through multiple pages and potentially thousands of lines of the index fund prospectus to know what’s in your basket.  That’s too much for most amateurs to manage in which case you’ll pay fees for a manager.  Brokerages like this.  See item #2 regarding management fees.

4) Investment diversity is frequently argued as a simple, brilliant form of risk mitigation.  The financial industry has taken the argument to the nth degree by selling the proposition that a fund of hundreds or thousands of companies offers greater diversification i.e., less risk, than a smaller grouping of individually held dividend paying stocks.  But is this true?  I can get considerable diversity or risk mitigation with 20-30 holdings in a well-chosen selection of dividend payers.  Adding hundreds of additional companies doesn’t reduce my risk much beyond that smaller holding – particularly if all those holdings are wrapped in a single package delivered by one financial institution.  In a future post, I’ll take a brief look at the probability underpinning the maxim of investment diversification. 

An index fund allows you to hold many, many companies at once providing the touted investment diversification.  However, I would argue that a vast array of companies is not necessarily better.  Warren Buffett agrees.  Or better, I’m of the same opinion as Warren, who said “diversification is protection against ignorance. It makes little sense if you know what you are doing."  The theory is most investors don’t know a post hole from their pie hole and should buy a huge basket of everything to limit risk rather than learning something about a few things and sticking with what they actually know.  The argument is great for the croupier class taking tine pieces of considerable investment activity via small management fees tacked onto index funds and ETFs.

5) Selective quality with individually held dividend stocks is much great than it is with an index fund or ETF.  Consider the estate sale in which a box of unknown stuff is auctioned off with little or no inspection by the bidders.  Bidders are attempting to buy the box at the lowest possible price hoping they’ll find a diamond among the rubbish they know they’ll get otherwise.  When you buy an index fund or ETF, it’s the same principle.  You’re buying thousands of companies in one fell swoop hoping the handful of gems more than offset the dregs and millstones you’ll invariably get.  It's less risky to pick and choose what you're putting your money into than throwing it over the wall and hoping for the best.

5.5) Additional thoughts:  Advocates of index funds and ETFs argue that diversification for small investors is easier with an index fund than individually held stocks.  This is true if you have only a couple hundred bucks to invest.  Once your investment basket has climbed above a few thousand dollars, I’m not sure that argument still holds.

A second argument is that index funds allow people to invest in with little risk, but complete ignorance.  Investors don’t have to read, research, or even think to participate safely in the market, or so goes the story.  I’m not sure this is a stellar idea to propagate but it’s a thing none-the-less.  It's better to put in a bit of effort when participating than diving in completely unaware.  Contrary to the old axiom, ignorance is not always bliss, particularly when investing for your future.

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.