Henri Cooke blogs on investing

Investing: Index funds vs dividend stocks 

 There are many different ways to invest in stocks but the two I am going to talk about are index fund investing and dividend investing. To begin with you may be wondering, what are they? Well, an index fund is a collection of stocks that track a specific market index. For example, the S&P 500 is a market index of the largest 500 companies in the US and there is an index fund that tracks the S&P 500. This fund buys an equal amount of stocks from each of these companies. Dividend stocks are a lot simpler, these are just shares of a company you can buy that give you a return on the amount of money you put into the stock. 

 The main two differences between these types of investing are the freedom you have and the effort you need to put in. When investing in dividend stocks you have more freedom than index fund investing. You usually aim for a yield of around 4-6% and with this money you can do whatever you like. This is helpful if you are a full-time investor because if you had £1,000,000 invested and had an annual yield of 5% you would already be earning £50,000 (excluding tax). With this money you could reinvest it into new stocks or live off it like a salary. However, in an index fund, not all stocks pay dividends and furthermore, the dividends have to be reinvested into the fund. This is a disadvantage as your index fund could be underperforming or you may have found a new stock that you want to invest your money into but you cannot and in both cases you are not making the most out of your dividends.  

Another flexibility advantage to dividend investing is the choice you have of what stocks you want and when you want them. Since the majority of index funds track the largest companies and not the best-performing companies, many index funds include disaster stocks. This is a stock that is about to crash and lose its value or has already started crashing. You cannot sell this stock as part of the index fund and therefore you are stuck with it and it can lose you money. Whereas, when dividend investing, if you believe one of your stocks is a disaster stock you have the option to sell this stock whenever you want, to avoid any losses. This works the same when buying stocks, if you see a stock that looks promising you can buy it but with an index fund you are stuck with the stocks in the fund. However, with this freedom comes the main disadvantage, risk. When index fund investing your money is diversified into a huge number of stocks so even if there is a disaster stock, there is a high probability you will also have a stock that is outperforming the market which makes up for the lost money. Because of this index funds in the US and other growing economies will normally average a return of 1.07%. Whereas with dividend investing, you normally have a portfolio of 5 or so stocks that you put your money into. Therefore, if one of your stocks crashes the money lost will be far greater than what is lost in an index fund. 

 An advantage to index funds is that generally once you have bought the fund there is little to no effort you need to put in. As explained earlier, the average index fund in the US will give an annual return similar to the market rate of around 1.07% (this has changed slightly this year due to COVID-19) and this doesn’t really change because if you picked your index well you will choose one that replicates a market that is in a growing economy, like the US. However, when dividend investing you have to be constantly looking at the companies you want to invest in or are already invested in by doing things like listening to conference calls, keeping up with their quarterly earnings, reading their 10-K and 10-Q and many more things. If you do all of this, you would hope to be able to beat the market by even just 2 or 3% because this could be a huge difference in the return of your stocks. Unfortunately, the reality is that most of the time you won’t be able to beat the market unless you do this illegally by getting information off owners of big businesses. Warren Buffet was so confident in this that he actually bet hedge fund managers $1,000,000 that across the course of 10 years they would not be able to beat the market rate, and of course they didn’t. 

This graph shows 3 of the biggest market indexes in the world and how their values have changed by percentage over the course of the coronaviruswhich in turn produces a roundabout image of how the stock market has fluctuated. As you can see from late February through to mid-March there was a huge crash, the Dow Jones and FTSE 100’s biggest crash since 1987. This is because as soon as countries were getting put into lockdown, shareholders started to panic sell. Since the majority of businesses weren’t going to be able to function properly people wanted to sell their stocks, but the other problem was that no-one wanted to buy them. This led to sellers having to keep lowering the price in order to attract buyers which creates this huge crash that the graph shows. Ever since this crash we can see that the market has generally been increasing and this may seem odd since economies are still receding but there are a few reasons for the increase. First of all, many big companies like Facebook and Amazon weren’t actually affected by the virus since their services could still continue and these are the sort of companies that hold most of the stock markets value. When people realised thisthey started to buy more stocks from these companies and this aided the market. Another reason is that governments started to ease lockdowns. This meant that businesses were able to open again and so they were making money which meant people wanted to buy their stocks again. However, the main reason for the increase is quantitative easing. This is where governments print cash and use it to buy gilts (government bonds) from the central bank to prevent hyper-inflation and so that the bank lends money on in order to kickstart the economy. A side effect of this is that interest rates on bonds then decrease which makes them a less attractive investment and stocks a more attractive investment. Therefore, when governmentused quantitative easing, money was pushed into the stock market and caused the increase in stock market values shown in the graph.