By: Dividend Sensei
The continued success of passive investing vs active fund management has been one of the biggest megatrends in the financial industry. For example, over the past year $303.3 billion has flowed out of high cost, chronically underperforming actively managed funds, while low cost, passive index funds, such as ETFs, have gained $437.3 billion. In fact, index funds now have a record $5.13 trillion in assets under management, a 34.5% market share.
I fully expect this trend to continue as investors realize the simple truth that the vast majority (about 85%) of Wall Street “pros” can’t outperform their indexes, thanks in large part to high fees, and overtrading.
Of course that doesn’t mean that the answer for all investors is to just park their savings into indexes, and wait to get rich. Yes, for those people who have little interest in investing, and don’t have the proper psychology/risk tolerance to take advantage of the kinds of crazy volatility the market occasionally throws out, index ETFs such as the Schwab US REIT ETF (SCHH), with its 3.3% yield, 0.07% annual expense ratio, low 12% annual turnover (very tax efficient), and exposure to 101 of America’s largest equity REITs, is a great idea.
IF you are able to master your emotions, build a solid, personalized investment plan that includes how to take advantage of market volatility, then you can, and likely will end up doing better with individual stocks in your diversified portfolio.
Consider this: The very reason that indexes are so hard to beat, even for the overpaid Wall Street “pros” is because the way funds are structured sets them up for underperformance and failure.
For example, whether or not a manager gets a bonus, or even gets to keep his/her job depends on how the fund did that year, (and whether or not the fund attracted new new inflows to grow its assets under management).
Which means that fund managers, if though they know that short-term volatility is helpful to long-term returns, (buy on dips) they often can’t do that. After all, if the REIT sector, as one example, falls 30% over the next year due to rising interest rates, then investors will likely panic and withdraw their funds from active REIT funds.
The managers will become forced sellers at the exact time that they should be buying high-quality, high-yield names on the cheap. BUT for most of them? Keeping your job, and attempting to chase the hot subsector to try to beat your peers, attract new capital, and get a nice bonus is more important.
Passive index funds? They don’t have this problem, because by definition they are set up as buy and hold funds, which eliminates market timing, which studies show are the very best way to guarantee long-term underperformance.
The simple fact is that the market, while crazy volatile, generally goes up, about 70% of years. Which means that you want to keep your capital invested at all times, to take advantage of the power of dividend growth stocks (which beat the market over time), to raise their payouts, and create a “hyper compounding” effect in which exponentially rising dividends, reinvested into exponentially more shares, create a river of cash that ensures long-term market beating returns over time.
SO here’s how you can combined the time tested truths of passive index funds with methods that are likely to result in you not just beating the market over time (and thus Wall Street), but trouncing it.
- Start with a Buy, Hold, Accumulate on Dips, and reinvest the dividends mentality: This is your base, from which you will build your exponentially growing investment empire and achieve your financial dreams.
- Be selective: Unlike Index funds, you are looking for the highest quality dividend growth names. By choosing wisely, and winnowing out the bad seeds over time, even a very diversified portfolio of 100, 200, or even 300 stocks will beat the market over time
- Embrace volatility like a lover: View crashes, and the higher yields they create as buying opportunities, lowering your overall cost basis, and raising your yield on invested capital.
- Be contrarian/a value investor: The market is ALWAYS irrationally down on some sector so rather than hoard your cash on the sidelines waiting for a crash that may or may not come for years, invest in whatever is cheapest at the moment (that’s on your carefully researched watchlist).
- Live as frugally as is comfortably possible: The more you can save and invest each month, the more powerful the effects of hyper compounding will become in your favor.
Apply these 5 simple rules to your diversified (studies say 20-50 stocks is generally best for most investors) dividend growth portfolio, and then wait patiently. Don’t watch financial TV, don’t panic or speculate about what the latest economic or earnings news release or interest rate hike, (or elections) means, because 99% of the time it means nothing for the long-term investment thesis of the company.
Just focus on building up as much discretionary capital as you can, for as long as you can, and deploying it per your personalized, well thought out investment plan. Do that and you’ll be surprised how quickly you can get rich, and achieve your financial dreams.