This gets pretty hairy pretty quick, so bear with me.
I’m currently 35 years old. Right now I’ve got about $19K invested in individual stocks in a taxable brokerage account. Particularly I’m taking a dividend-growth approach in this account in hoping to eventually have some significant dividend income. And even though it’s of course very likely that I won’t beat the market over the long haul, I’ve discovered that there are plenty of other advantages to doing this that you don’t get with index funds. But I’m wondering if it’s worth it to keep with this approach for a taxable account, or if I should just go to a mix of index funds. I started this account so that I’d eventually have a decent stream of passive income long before I’d be able to tap my 403(b) penalty-free, in the hopes of FIRE.
In my 403(B), I’m investing in a VTSAX-like fund. At about $100K currently, that’s where the majority of my money is. And I’m pretty confident that I’ll be able to retire on that alone one day. But if I’m going to shoot for early financial independence, I need some stream of income long before I can take withdrawals from that penalty-free. I’m aware of the 72(t) tax law, but the dividend income, while it may take a little longer, it seems more hassle-free.
Right now I’m in the 15% tax bracket, and I’ll probably be there for a while since I put a significant amount of my pre-tax income in my 403(b), and I raise my contributions with my annual raises.
So here are the pros of investing in individual stocks over an index fund or mix of index funds.
-Due to being in the 15% tax bracket, the dividend income in my brokerage account is almost entirely tax free. But I think this would be true with index funds as well. The only reason it isn’t entirely tax-free is because of the few REIT positions I have.
-I can manufacture my own expense ratio. At $7/trade, if I invest $1400 with each buy, that comes out to a .5% effective expense ratio. Of course, Vanguard blows me out of the water with their index funds, but .5% still isn’t too bad. But at the end of 2016, I had an expense ratio of 0.62% due to some smaller trades. Still, not too horrible.
-To a lesser extent, I can manufacture my own dividend yield. I have a lot less control over this one, but I can still do significantly better than many index funds on this front. I can buy individual stocks when they’re undervalued, and get a higher dividend yield as a result. And with dividend-growth stocks, that yield will increase over time. At the end of 2016, my yield was 3.78%. Reading other dividend growth investor blogs, this settles to around 3.5% during the accumulation phase after enough holdings. Vanguard’s dividend-focused index funds currently have yields of 1.92% for the Dividend Appreciation Index Admiral Shares fund (VDADX) and 2.97% for the High Dividend Yield Index (VHDYX). And their REIT index fund (VGSLX) currently has a yield of 3.87%. I’d probably do an 80/20 split with the REIT fund if I took the index approach. With VDADX, that would give me a current yield of 2.31% (more than a full percentage point below what I currently have!), and with VHDYX that would give me a yield of 3.15% (more than a half percentage point below what I currently have). I know these don’t look like huge differences, but in the long haul, these can end up making large differences in when you can stop accumulating shares and start using the passive income from the dividends. And when you do stop accumulating shares and start using the passive income with the individual stocks, your expense ratio basically goes to 0! You might make an occasional trade here and there, incurring a commission fee, but they’d be infrequent enough that your effective expense ratio is basically negligible. And this has the added benefit of lowering your average on-going effective expense ratio over the years, whereas with a fund you will ALWAYS be charged X% expense ratio, even after you stop accumulating shares. It’s worth noting that the annual distributions in all of the Vanguard funds that I mentioned go up as well when averaged over 5-year periods (the longest time that Vanguard gives distribution amounts for in their annual reports), but the income is potentially more volatile from the funds, believe it or not.
-I alluded to this in the above paragraph. I can buy companies when they’re undervalued when buying individual stocks. With an index fund, I can’t do this. So in the long term, I can potentially get better value for my money. But with funds, I have to buy when they’re low AND when they’re high.
Of course, the beauty of the index fund(s), is that you basically “set it and forget it” and let compounding interest do its thing. And of course, low fees.
So to you, dear reader, I ask, what do I do?
Keep investing my taxable account in individual stocks?
Go with the 80/20 split between one of the Vanguard dividend index funds and the REIT index fund?
Or just throw it all into Vanguard’s Total Stock Market Index fund (VTSAX) and then withdraw in a more normal manner, ignoring dividends? Remember, I’m investing in something extremely similar to this in my 403(b).
I’d love to hear from anyone, but ideally I’d like to hear from people that have also done both index fund investing and individual stocks.
Thanks ahead of time all!