Investing in Dividend Stocks vs. Vanguard Index Funds

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Many Canadian investors believe that you can obtain market beating returns by investing in companies that have a long history of paying dividends. It’s even better when these companies are increasing their dividends year and after year.
In Canada, suitable stable dividend companies are found in a few sectors like financial services (banks and insurance), utilities (electric and pipeline), food and drug retailers, telecom, and transportation.

Over the past 30 years these companies have in fact been better investments than the broader Toronto market which includes more volatile sectors like oil and gas and mining. Investors who bought these large companies such as Royal Bank, TD Bank, Power Corp, Fortis, Enbridge, Loblaw, Sobeys, BCE, Rogers, CN Rail, CP Rail and held them have seen growing share prices and dividends.

When I started investing 25 years ago, there were no broad market index funds. You either had to buy an actively managed mutual fund and pay the very high fees or do it yourself. Good quality dividend stocks were an excellent alterative to high priced funds.

Does that mean that you should stick to picking individual dividend stocks today or should your consider investing in index funds that buy the whole Canadian market, Vanguard’s VCN?

My personal take on this is despite the success over the past 30 years, whole market index funds are the way to go looking forward. I can think of a couple of reasons for this:

1. We are in a 35 year bull market for bonds, meaning interest rates have been falling consistently for the past 35 years. In 1981, the rate you received for buying Canada Savings Bonds was around 19%. Today, the rate is less than 1%. In an environment where interest rates are falling, dividend stocks outperform. The value of the growing dividends is greater since people are looking for alternatives to falling interest rates. We’ve reached a point where interest rates can either stay low or go up. There really is no more room to go down. If they start to go up, then dividends become less valuable to investors as bonds compete for investor attention. There is a reasonably good chance this will happen at some point in the next few years. If you believe that everything eventually reverts to the mean, then interest rates should be higher in the future and dividend stocks could underperform the overall market. Beware that things could always be different this time.

2. There are only a few sectors in Canada that offer steady dividend growth over years or decades. In the past year or so, many investors have lost huge sums of money when oil and gas companies, who had paid dividends for a few years in a row, had to reduce or eliminate their dividends. Companies that operate in very cyclical industries like oil, gas, mining, and manufacturing are not good candidates for long term dividend investing. As a result, Canadian investors are forced to keep their money concentrated in 5 or 6 sectors. In some cases, there may only be 1 or 2 players in the sector. The Canadian market is just not that broad compared to American or European markets and there are sectors that don’t really exist much in Canada (technology, pharmaceuticals, consumer staples). This increases long term risk as there could be a catastrophic event or major technology change that decimates a whole sector and, in the process, seriously damages your retirement plans. No one predicted that many large American banks would be on the verge of bankruptcy in 2009. Many of these companies eliminated dividends and their share prices have not recovered 7 years later.

Consider how much easier and less risky it is to just buy the whole market including the good dividend payers and forget about it. Historically buying low cost index funds have performed very well, especially for your international stock exposure which, according to many experts, should be about 1/3 of your portfolio.
For the Canadian component of your retirement savings, you may do better with dividend stocks, assuming the past is like the future, but why take the risk? Buying the whole market makes it less likely that you will make a big mistake.

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