Ind. stocks vs. index funds: pros & cons. Seeking advice


#1

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! :smiley:


#2

Go with the index fund. I beat the S&P 500 for 5 years following the economic meltdown by buying undervalued individual stocks, but during the last two years the index funds have beat me, and sometimes what appear to be undervalued stocks become value traps.

If you’ve got the time and interest to research individual companies and are highly knowledgeable regarding balance sheets and income statements, then buying individual stocks might make sense, but the chance of beating the S&P 500 over the long haul in that way is remote.

Here’s how I look at it; the smartest investors in the world (such as Buffet, Munger, Lynch, etc) pick stocks as a full-time business. Buffet has averaged something like a 19% return over 50 years, but he is the rare exception, and he represents the best that can be done. Something like 93% of money managers cannot beat the S&P 500, and even good ones, like Miller, eventually make big mistakes.

With a Vanguage index fund the fees are low, and the long-term return has been something like 9%. That’s very hard to beat unless you’re very very smart and have a high tolerance for risk.

Early in my investing career I put $10,000 into an index fund and $20,000 into a managed growth and income mutual fund. For about three years both accounts rose in tandem as the market rose. Both accounts doubled in value. I rarely even looked at the statements I received, but one day I happened to look at the two accounts and discovered that they both contained about $20,000! I was totally shocked and immediately looked to see what had happened. On one particular day the growth and income mutual fund had lost half its value whereas the index fund showed a steady rise in value. After doing some research I discovered that the manager of the mutual fund had made one bad bet on something which had slaughtered that fund’s return. I sold the mutual fund and never bought another one. Not only at the fees high, but the managers often make costly mistakes.


#3

I have to say that over years/decades of sitting through investment consultants giving quarterly performance reports to committees, I’ve heard commentary on value versus growth flip flop regularly. Sometimes its growth stocks, sometimes its value. I personally wouldn’t bother having a style bias, just a passive market exposure works for me.


#4

I am like you - I am a dividend stock investor. I have two criteria for investment - stable income business I understand and whose products help, not hurt others.

The S&P 500 index fund is just a mix of various stocks by largest market cap. And not to pick on Phillip Morris (now called Altira) but they sell cigarettes internationally and make up 0.847616 of the S&P 500. So a million dollars in that index fund would hold $8,476 or 132 shares which earn $7.38 each.That is $1003 in earnings per year - and a mandate to management to increase those earnings!

Did you know that 3/4 of bangedesh children smoke? The leading brand there? Marlboro. Their meager earnings, addition and lower mortality rates pays for a part of every S&P 500 index fund holder. And that does not seem to match the wonderful values and caring for others I have seen expressed here.

My opinion (since you asked): stop trying to beat the market and go ahead and buy individual stocks. Having supplemental income from stable dividend stock is good enough. Or at least buy indexes consisting of business that match your particular values.

Getting to financial independence as fast as possible is not the most important thing here.You will sleep much easier known you did not create incentives or benefit in anyway from this kids smoking.


#5
  1. For all the reasons you’ve heard elsewhere, I am an index fund purist. Assume Buffet is on the other end of every trade you make - he’s going to win, and it’s going to be at your expense. Seek excitement in the bedroom, the horse races or via a budgeted gamble at Vegas; keep investments boring.

  2. A much bigger win for you might be a Roth conversion ladder to move your tax-deferred retirement funds into tax-free retirement funds. If you are in or under the 15% bracket, this is a huge win for you with decades to compound and tax-free withdrawals. Resource articles 1 and 2 courtesy of @madfientist and Justin at rootofgood, respectively.

Best of luck,

CD


#6

Though I didn’t really mention it, this is another reason why I like picking individual stocks in my taxable account: I can leave out the ones I disagree with. But if the goal is FI/RE, this should be a tertiary concern at best.

But the ease of index funds is appealing. But I also already have an account that will keep up with the market. I struggle with this issue because there are benefits on both sides, even if you don’t beat the market picking individual stocks. :confused:


#7

I have holdings in a 401k (date fund) along with a diversified Vanguard portfolio that total ~1.2M. I recently created an M1 Finance account to build a 25 piece dividend stock portfolio. I made a very small deposit to get my feet wet to learn all about dividend stocks, and associated terminology etc. I am curious to see what companies are in your portfolio and what criteria you use to select them. My rule is to only add to this with monthly funds I get for my “allowance”.


#8

Here is an overview of good set of criteria


#9

I’m not sure who you’re asking, but this is what’s in my taxable account so far. I’ve got only ten holdings at the moment since it’s still a fairly young account at only ~$19K and about 2 years old.

-American Express Co. (AXP)
-Johnson & Johnson (JNJ)
-Realty Income Corp. (O) - REIT
-Omega Healthcare Investors (OHI) - REIT
-Procter & Gamble Co. (PG)
-Visa Inc. (V)
-V.F. Corp. (VFC)
-Verizon Communications Inc. (VZ)
-Wells Fargo & Co. (WFC)
-W.P. Carey Inc. (WPC) - REIT

The post above by @GRuga gives some good guidelines. I also like to look at the history of the company, and the track record. AXP, JNJ, & PG have all been in business for over 100 years! And of course, the growth potential going forward. As the industrialized world gets more populated, there will be more demand for the products that JNJ & PG make. And AXP has inflation protection built right in!


#10

Great article. I really agree with the three basic criteria. An additional criteria I use is to make sure that the earnings per share is greater than the dividend payout. I have seen many companies paying an incredible dividend, but that cannot be sustained for long.


#11

Thanks for sharing your portfolio. I cannot disagree with your logic in your selections. Have you stayed with your initial 10 or did you start with a few and slowly added? Do you have an equal weighting across your portfolio?


#12

Basically I’ve just slowly grown the portfolio. So I didn’t initially start off with all 10 of these positions. Basically I’ve put $350 into my taxable account each month, and when there’s ~$1400 cash, I’ll put into an investment, whether that’s a new position or a holding I already have.

Right now VFC, VZ, and WFC are my largest positions. But I’d really like JNJ, O, and maybe AXP to be my largest positions. But the “problem” with buying shares of good companies is that when you do have a chance to get them at good prices, the stock price tends to go up soon after, so I haven’t been able to put more money into those positions due to valuations.

All this being said, this is still a very young portfolio. Assuming I keep my taxable account invested in individual stocks, there will be many more positions to come.


#13

When did you buy WFC? Just curious. I bought JPM and WFC during that flash crash (and on the day bank stocks were down 2.5% or so) in august a few years ago. JPM has done ridiculously well but WFC is still at what I bought it for… Buffet loves it though so probably keep it

(also I’m definitely not advising to pick stocks rather than index)


#14

I’ve bought shares in WFC multiple times, the most recent being when the news came out about all the fake accounts and the share price took a dive.

The dates of my purchases are:
10/14/14 - 2 shares at $49.68
3/7/16 - 24 shares at $49.90
10/3/16 - 17 shares at $44.06


#15

Ah nice. Better than me


#16

@ Josh - wow - what a lot of overlap - I have 11 holdings (including Verizon, Amex and Wells Fargo) - apparently we have similar criteria for businesses and pricing. I suspect you have also ready chapter 20 of the Intelligent Investor. :):sunglasses:

We pick up WFC in May of 2015 , January of 2016 and again in June of 2016.


#17

Good to hear I’m not alone in my purchases. I guess I’m doing something right. :stuck_out_tongue:
Admittedly I haven’t read all of the Intelligent Investor. I got about a third of the way through it and stopped. It’s pretty dry reading. But I’ll definitely give it another go.


#18

Sounds like you are already conducting your choices using the principals in the book so I am not sure it will add much for you. In my opinion one only needs to read chapter 20 - or whichever chapter is called margin of safety. That is the revolutionary concept in the book (well, at least for me).

Example of it in practice:
Charlie Munger waited not years but decades and made one move over a few weeks. He invested all Daily Journals $20 million in cash during that period. Decades of waiting. And he didn’t buy on slow decline in 2008. Instead, one move in 2009. The result? The company now has $160 million in stocks and dividends now comprise almost 10% of the companies revenues. The companies they purchased are still cheap by almost any measure so there is more to come.

The companies trajectory is now changed because he bought high quality companies when the price was so low the downside was very low and the upside notable (margin of safety)

Anyway, I really like your portfolio and am sure if you hang on a few decades you will find the results more than satisfactory.


#19

Now that’s patience! Thanks for sharing that. Pretty interesting stuff.

Maybe I’ll just go back and read chapter 20 of the Intelligent Investor. :stuck_out_tongue:

I still don’t have a lot of confidence in myself in picking individual stocks, and honestly I probably won’t keep up with the market in the long haul, but I do like the other benefits as I noted above.

But I’m still considering switching to Vanguard index funds. Comparing their expense ratios to investing in individual stocks, there’s just no way I can beat them, and I’m guaranteed market returns.

Back and forth, back and forth, back and forth…


#20

Over long periods of time research certainly indicates that you will have a higher account balance with index funds. And on the ethics side there is an argument to be made that who are we to judge what other people purchase or consume and an index fund is a vote on free markets in general.

So it’s a smart choice.