After years of dedicating time, energy, and dollars to the pursuit of wealth building, I’ve come to the conclusion that cash flow is what I prioritize most from my investments. Now, while that might be my priority, it certainly doesn’t have to be yours. Index funds have gained immense popularity for several reasons. One key factor is their passive investment approach, tracking a specific market index rather than relying on active management. This passive strategy often results in lower fees compared to actively managed funds.
Additionally, index funds provide broad market exposure, reducing the risk associated with individual stock picking. The simplicity and transparency of index funds appeal to many investors, especially those seeking a long-term, low-maintenance investment strategy. This is where funds like Vanguard Total Stock Market ETF (NYSEARCA:VTI) come in. It’s an easy solution to give investors instant diversification across every industry while making it extremely easy to grow your wealth.
I won’t pretend there aren’t merits to investing in index funds. We’ve seen all of the stats that reinforce them. Such as:
- Lowest expense ratios in the industry. VTI’s 0.03% expense ratio means that with $1,000 invested, you are only paying $0.30 in management fees.
- Index funds regularly outperform the best managers on Wall St. in total return. Warren Buffett has always recommended them.
- They offer instant diversification and reduce risk from individual stock picking.
However, what if I told you that this may not be the best approach for a lot of us who want to quit the traditional workforce early? This is especially true if you are a high-earner with a lot of disposable income. Index funds are great for passive wealth building over long periods of time to fund a traditional retirement. I do not think it is useful for those trying to create a sustainable income stream to replace their job income for extended periods of time.
Portfolio & Performance
The Vanguard Total Stock Market ETF is an exchange-traded fund that focuses on investing in the public equity markets of the United States. This fund strategically allocates investments across various sectors and targets both growth and value stocks, which gives a diversified market capitalization.
This is exactly the type of return that makes index funds so appealing. Effortless growing your investments by 200% without much effort sounds like a good deal. On top of this, you are instantly diversified into more than 3700 individual companies across 11 sectors. Here are the top ten holdings by weight:
|Alphabet Class A
|Meta Platforms Class A
|Alphabet Class C
|Berkshire Hathaway Class B
As you can see, the majority of the fund is held up by tech-oriented companies. Having over 3,700 companies as a part of your portfolio is great but I do think there’s such a thing as over-diversification to the point that results in overkill. Out of the 3,700 companies, there are probably a ton in that batch you wouldn’t necessarily care to invest in I bet.
While VTI does offer shareholders some form of income and dividend growth, I don’t think it would match the needs of someone who is dependent on this income. With a dividend yield of 1.4%, you’d need several millions invested to produce any sort of income stream that’s livable. Even with $3 million invested in VTI, you’d only earn $42,000 in dividend income. $42,000 is still below the average income level in the US. For reference, the average individual income in the US is about $60,000 while the median US household income is $71,000.
While you do get some growth in dividends, it just isn’t high enough to justify a position in a portfolio that you eventually want to use for income. With such a low starting yield, I would like to see a higher dividend CAGR over the last 10-year period. A growth rate of 7.4% is very underwhelming for such a low-yielding fund but at least the fund is consistent with 22 years of raises.
FIRE & The 4% Rule
I’m sure most of you have heard of the FIRE movement by now. If you haven’t, it’s a group of individuals who are determined to reach financial independence and retire early through their investments. FIRE: Financial Independence Retire Early. The most common method people in this community use is plowing cash into index funds such as Vanguard’s Total Stock Market Fund or Vanguard’s S&P 500 ETF (VOO). The idea is to eventually accumulate enough in these index funds to pay for your lifestyle by following the 4% rule.
The 4% rule, often referred to as the Safe Withdrawal Rate, is a retirement planning guideline introduced by financial planner William Bengen back in the mid-90s. This rule proposes that retirees can safely withdraw 4% of their initial retirement savings annually, with adjustments for inflation, without depleting their funds over a 30-year period. In practical terms, if someone has $1 million in retirement savings, they could withdraw $40,000 in the first year. The 30-year time horizon is a key assumption, and the rule is based on historical market data.
Referencing the chart above, the idea is that your portfolio will outgrow the 4% distribution you are taking. So using the $1 million portfolio example, even though you are withdrawing $40,000 in year one, your portfolio size would grow anywhere between $80,000 – $120,000 on average per year. Infinite money glitch it would seem, right? Wrong.
Unfavorable market conditions, including prolonged bear markets, may impact investment performance and jeopardize the sustainability of the 4% withdrawal rate. Additionally, higher-than-expected inflation rates can erode the purchasing power of withdrawals over time. Imagine how much pressure all of the people who retired in 2022 were experiencing with the costs of everyday items like groceries at all-time highs. Unexpected increases in spending needs and changes in healthcare costs can all pose threats to the 4% rule.
Here is my one single problem with this approach: It requires you to actively sell shares to fund your retirement. Following this strategy means you are actively selling the asset that pays you money. I know studies and data tell us that this strategy is sustainable for at least a 30-year period, but if I outlive the 30 years or want to simply pass on a growing nest egg to my children?
Why A Dividend Approach Is Better
Investing for a stream of dividend income presents compelling advantages over traditional index funds in my opinion. These reasons make this approach an attractive option for investors seeking long-term stability and reliable income without ever having to sell their shares. Dividend-paying stocks, REITs, BDCs (Business Development Companies), MLPs (Master Limited Partnerships), and CEFs (Closed End Funds) provide a consistent stream of income through regular dividend payments. This feature is particularly advantageous for investors who prioritize passive income, such as those in retirement, offering a reliable cash flow to cover living expenses.
Reason #1: Growing Income
Dividend growth stocks go beyond providing a steady income; they have a history of increasing their dividend payments over time. This not only ensures a growing income stream but also helps investors keep pace with or even outpace inflation. Companies that consistently raise dividends often demonstrate financial strength and confidence in their future earnings. Take a look at the entire list of Dividend Kings for example. These are companies that have increased their dividends for over 50 consecutive years.
Reason # 2: Potential for Higher Total Return
Unlike index funds, which primarily focus on capital appreciation, dividend stocks offer the potential for both capital gains and income. Reinvesting dividends through dividend growth stocks can lead to compounded returns over the long term, contributing to a higher total return compared to some index funds. Here are some examples of funds or stocks from different industries that have crushed VTI’s total return. One thing they all have in common: a high dividend yield of over 5%.
- Capital Southwest (CSWC) a BDC that has a dividend yield close to 10%.
- Realty Income (O) one of the best REITs in the world has a yield of 5.4%.
- Enterprise Products Partners (EPD) an MLP has a yield of over 7%
- BlackRock Health (BME) is a CEF with a yield over of 6%.
I like to use these examples to demonstrate that it is very possible to beat the total returns of index funds while also having a diversified portfolio. The best part is that you’d be outperforming the larger market while also having a higher stream of growing dividend income. If interested, I’ve published individual analyses on most of these for reference.
Reason # 3: Never Selling Shares
Investing in dividend stocks offers a distinctive advantage in the form of never having to sell shares to meet income needs. This stands in contrast to index fund investors who may find themselves compelled to actively sell the very assets contributing to their wealth. The significance of this distinction lies in the sustainable income stream provided by dividend stocks through regular dividend payments. Investors can rely on this steady income flow to cover living expenses or fund financial goals without the necessity of selling shares.
This approach aligns with a long-term investment strategy, allowing investors to maintain ownership of high-quality assets and avoid forced selling during market downturns. Imagine if you retired during the crash of 2020. By retaining shares, investors in dividend growth stocks can benefit from both the compounding effects of dividends and potential capital appreciation over time.
While dividend income can be an attractive strategy, it’s important to play both sides and bring up the potential downsides. One of the big ones regards the tax implications associated with certain investments. Assets like REITs and BDCs are often taxed as ordinary income, which may result in a less tax-friendly approach compared to other investment vehicles. This is not a problem when you invest in an Index fund like VTI since the dividends are classified as qualified.
This can snowball into a bigger headache as your portfolio size grows. If you are earning $40,000 in qualified dividend income, you probably owe little to nothing in taxes. Whereas $40,000 in ordinary income would result in a larger tax bill similar to income from a W2.
While I would never be silly enough to recommend you completely disregard quality index funds like VTI, I am willing to simply recommend that you figure out what your investing goal is. For me, the pursuit of wealth building has led to a realization of the importance of prioritizing cash flow from investments. While index funds have gained immense popularity for their passive approach and broad market exposure, there are compelling reasons to consider an alternative strategy focused on a stream of dividend income. Despite the merits of index funds, including low expense ratios and historical outperformance, the unique advantages of dividend growth stocks become apparent, especially for those aiming to retire early or seeking a sustainable income stream.
A dividend approach has the distinctive advantage of never having to sell shares. Dividend stocks can provide a reliable and increasing income stream, aligning well with long-term investment goals without the need to liquidate assets. In comparison to index funds, the dividend approach allows for greater control of asset diversity, emphasizing the importance of generating passive income to replace job income over extended periods. As investors navigate their wealth-building journey, the choice between index funds and a dividend-focused approach should be guided by individual financial objectives and preferences.