Dividend Investing vs Index Funds: Which Is Better for Financial Independence?

BiggerPockets Money

In this episode, hosts Mindy Jensen and Scott Trench debate the merits of dividend growth investing with guest Eli Breece from Dividendology.

Key takeaways

• Eli Breece highlights that the Dow Jones U.S. Dividend 100 Index returned roughly 1,750% from 1998 through the recording date, significantly outperforming the S&P 500's 940%.
• Mindy Jensen points out that during the 2008 financial crisis, 33% of dividend-paying firms in the S&P 500 reduced or stopped their payouts.

Main topics

• Dividend Growth Investing
• Sequence of Returns Risk

Notable quotes

I'm not here to make it sound more glamorous than it is.

Conclusion

The episode provides a nuanced look at whether dividend growth can ser

Transcript preview

Speaker 1 (0:00) Dividend investing is one of those topics that we have strong opinions about, so we haven't really covered it a lot on the show. While Scott and I both have a heavy bias against dividend investing, not everyone in the community feels the same way. So today, we're bringing on Eli Brees from Dividendology to challenge what we think we know and answer the question, Can dividends actually be a good way to build wealth and pursue FI? And as always, this episode is not investing advice. This podcast is for entertainment and educational purposes only. Speaker 1 (0:36) Hello, hello, hello, and welcome to the BiggerPocketsMoney podcast. My name is Mindy Jensen, and with me as always is my reinvested co-host, Scott Trench. Speaker 3 (0:44) Thanks, Mindy. I'm going to buy back our time and jump right into the episode today. We are so excited to be joined by Eli Brees. Eli is a former real estate analyst who took a different approach to building wealth, shifting his savings into a dividend-focused portfolio rather than relying solely on a traditional retirement account. He shares his journey, strategy, and insights on his YouTube channel. called Dividendology. And today, he's here to help us better understand more about dividend investing. So without further ado, Eli, welcome to the BiggerPocketsMoney podcast. Speaker 2 (1:11) Scott, Mindy, it's such a pleasure to be here. I've enjoyed watching your show over the years, and I really appreciate you having me on the show. Speaker 3 (1:17) Awesome. Welcome. And to get things started, we're going to make the case against dividend investing here to get going. And Mindy, you want to take this and tell Eli why we are against dividend investing, generally speaking, at least coming into the conversation. Speaker 1 (1:30) Okay, Scott, here are my biases on why I am not pursuing a dividend investing strategy. Number one, it's not guaranteed. The company can simply stop paying out a dividend at any time. Money paid out in dividends is not money being reinvested into the company. It's not the free money that you think it is. Could be very tax inefficient. And you're primarily buying individual stocks instead of... index funds. Yes, index funds pay a dividend, but not every stock in that fund pays a dividend. That's not why you invest in index funds. But in order to be a dividend investor, you are focusing on individual stocks. Scott, do you have anything to add? Speaker 3 (2:07) My issue with dividend investing is that there are five uses of capital, generally speaking, that I... company can proceed with. One is buying back shares. One is investing in operations. One is a dividend. One is acquiring companies. And the last is building up their cash position or paying down debt, you know, doing something on the balance sheet. By focusing on dividend investing, specifically growth dividend investing, which we're talking about today with Eli, you're overweighting the companies that feel that that's the best use of capital relative to the rest of the economy. And I'm not sure there's compelling evidence for that. In addition, to the concerns you listed, Mindy, including taxes and the realization of income you may not want, especially in early retirement. Eli, why do you invest in dividend growth Speaker 2 (2:45) stocks? So there's a few different reasons I specifically invest into dividend growth stocks. Number one, perhaps the most important is it is a total return strategy. There's great studies from S &P Global we can look at today that over full market cycles, dividend growth investing actually does outperform. The second is perhaps almost just as important is it completely alleviates the sequence of return risk. which we can dive into more what that actually looks like. But it's the idea that if you're living off the 4 % rule in retirement, essentially, if you retire into a bear market, you're going to run out of money. Versus a dividend growth strategy, you continue to receive your income, that income grows over time, ideally at a rate above inflation. And thirdly, dividend growth forces you to actually focus on the underlying fundamentals of the company. It forces you to be a long-term investor. If we look at the three sources of returns, we have dividends, We have share price appreciation. And then we have, which again is the result of earnings growth or that changes in the valuation multiple. I can't predict what sentiment will be like and what changes in a stock's valuation multiple will be in the short term, but I can project future cash flows and what dividends will look like. So that's my case for dividend growth investing. I'm looking forward to diving into this with you guys. I Speaker 3 (3:56) love it. Thank you for stating this because there's like several misconceptions in the personal finance world around. dividend investing. And by the way, what you just said is an academically supported worldview that is also challenged by credible people that say, no, there's a very famous theorem, Modigliani-Miller, that says, nope, that's completely false. And in a frictionless marketplace, the dividend yield is in policy is totally irrelevant to your long-term total returns. But there's also an academic case for what you just said, where dividend investing does insulate you from sequence of returns risk to some degree. So there's a serious component to it and a real challenge to it in the marketplace. So Speaker 1 (4:36) with sequence of returns risk, you are trying to mitigate the fact that the market goes down while you're pulling out money in the beginning of your retirement. But if the market goes down, companies stop paying out dividends or lower their dividends. So I don't really see that as a hedge against sequence of returns risk. Speaker 2 (4:57) Yeah, I would completely disagree with that. So I actually had a conversation with David Bonson the other day. He manages $10 billion utilizing a dividend growth strategy. And he actually started his career in 1998 at the peak of the dot-com bubble. And he saw all of his clients who he was managing, you know, all this money. And they ran out of money if they were utilizing the 4 % rule. But if you look at a lot of the underlying companies, even stocks that, like Texas Instruments, for example. So Texas Instruments at the peak of the dot-com bubble took 17 years to recover from their all-time high, which is just absolutely brutal. And that's not even including inflation. If you include inflation, who knows what that would be. But they increased their dividend payout by over 2,300 % during that same 17-year time period. The dividend was never reduced. There's plenty of stocks that actually never reduced their dividends during the dot-com bubble. So really the argument you have to make... I think Mindy would be, how do we find these stocks that don't reduce their dividends during these type of scenarios, right? Ironically enough, this is where the outperformance that I just cited comes from. So S &P Global, I was looking at the study the other day. They show that the Dow Jones U.S. Dividend 100 Index, they did back-tested data starting in 1998, has returned roughly, to around the time of recording this video, around 1,750 % cumulative return, while the S &P 500 is 940%. Now, the obvious... pushback to that is that was right before the dot-com bubble. And that's absolutely true, right? One, that doesn't eliminate the fact that real people were retiring into the dot-com bubble and ran out of money when utilizing a withdrawal rate. But number two, it points out where does that outperformance over full market cycles actually come from? And what the Hartford Fund study shows us, it's a great study, but it shows us that dividend growth stocks achieve most of their outperformance during bear markets. So stocks that don't pay dividends, what this study showed, do typically outperform dividend growth stocks in raging bull markets, which there's no doubt we've been in really over the last four years since 2022. But the outperformance during bear markets is so much that over full market cycles, like we've seen over the last 30 years, dividend growth stocks have done exceedingly well. And like the total returns I just cited, it's quite strong. And the last thing I would add to that, they did another study of the Dow Jones U.S. Dividend 100 Index starting, I believe, in the year 2001. to kind of bypass the dot-com bubble. And again, it outperformed a total market index. So if we're going to talk strictly bull markets, Speaker 3 (7:18) you Speaker 2 (7:18) know, dividend growth investing will do well. It probably won't outperform when we have stocks like Palantir and SanDisk running 300 to 600%. So that's the case, one, for total return strategies with dividend growth, but also eliminating sequence of return risk. Speaker 3 (7:31) This is the case, and again, it's contested, right? By the way, I don't think a lot of people run out of money with the 4 % Speaker 2 (7:37) rule. Can I add a caveat to that real quick, Scott, if you don't mind? Go ahead. I hate to interrupt you, because you're right. The 4 % rule actually has a very high success rate. It's sitting at roughly 95%, I think. It was like 95, 97 % off the top of my head. But here's the issue with this. I was looking at the study the other day. Anytime the Shiller-Cape ratio is above, I hate to say the wrong data point. I want to say it's above... 2021-22, the 4 % success rate drops to about 75%. And our current CAPE multiple is sitting at about 40, which is the equivalent of the dot-com bubble, meaning the 4 % rule currently has a 0 % success rate at current valuation multiples of the market. So yes, you're right. Over the whole time period, incredibly high success rate. At current valuation levels, it's... literally a 0 % success rate. The caveat is, yes, maybe we'll have faster earnings growth with AI, but that's just the reality of what the data is currently telling us. Speaker 1 (8:32) When you're ready to start your business, Northwest Registered Agent helps you do more than just file paperwork. You get all the tools to build a real business identity from day one. A business address, website, phone number, operating agreement, free guides, and more at no extra cost. Northwest Registered Agent has been helping small business owners and entrepreneurs launch and grow businesses for nearly 30 years. 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Speaker 3 (10:33) I've been worried about this since early 2025, the Shiller Cape, and I've been looking silly for that entire time period. I agree with that concern. And then the question is, what do you do about it? And your answer is dividend growth. And I think there's lots of other answers out there as well. But I want to go back to this point that you've made around the withdrawal sequencing, because the reason for a bear market, I believe, is a huge part of the argument you're making. If what is happening in the bear market is the company is unable to generate cash flow to pay out shareholders, your thesis breaks on growth dividend investing. If the reason for the bear market is multiples have come down and cratered, now all of a sudden that is the argument for growth dividend investing. Because if I own the S &P 500 and I'm forced to sell it into a deep bear market at seven, eight times earnings, that's where I get crushed. as an investor in an index that's not dividend investing. If the cash flows are the same, you know, are growing throughout that time period, and I'm receiving the dividend portion from it, then I'm never selling the golden goose during that period, and I'm just harvesting the eggs. That's where the crux of this argument for dividend growth comes in, right? You're absolutely Speaker 2 (11:42) spot on because we can sit here all day and talk about, oh, dividend this, dividend that, but free cash flow is the only thing that matters. It's the only thing that matters because ultimately dividends are paid out of free cash flow. You talked about capital allocation right at the intro of this podcast. And that is the most important topic for us to even touch on if we're going to talk about any type of investing, capital allocation and free cash flow. How is a company using its free cash flow? So if a company's free cash flow is declining in a bear market, then absolutely that dividend is at risk unless maybe the free cash flow payout ratio was only 20 to 30%. So really, the conversation you have to have is like, how do you find stocks that can maintain their dividend during these market pullbacks? You know, if you're buying an Altria, who's currently sitting at an 80 % free cash flow payout ratio, and they see a 10, 20 % drop in free cash flow in a bear market, then the dividend's getting reduced. It's that simple. So yes, you're right. The caveat is I think there are instances specifically when you're picking individual stocks where you can find examples of stocks that can maintain even during, you know, turbulent growth periods for the market. They can maintain their dividend. I Speaker 1 (12:45) was a little stuck on this when you said that, you know, oh, most of them didn't reduce their dividend. Speaker 2 (12:50) Oh, well, I'll be careful what I say. I don't know about most. There's a lot of examples, right? There Speaker 1 (12:54) were plenty of companies that continue to pay out dividends. I can't remember exactly your words. So I looked it up. And during the dot-com era, you are correct, exceptionally low, like fewer than 1 % of people, of companies stopped paying out their dividends. In 2008, we had... 5.9 % of S &P 500 dividend payers completely stopped and 33 % of all dividend paying firms reduced or stopped. So that 33, I would assume, includes that 5.9%. So 5.9%, I can see that being like, okay, not such a big deal. However, if I am in that 5.9 % of the S &P 500, that's a huge... to me. And 33 % reduced or stopped paying out. 33 % of the companies in the S &P 500. But again, if that's where my money is at, 33 % of dividend paying companies. Speaker 2 (13:46) Right. I follow. Speaker 1 (13:47) So I just want to clarify because somebody's going to be like, it wasn't 33 % of the S &P. Speaker 3 (13:52) Well, that's it, though. That's it. In 2000, the dividend payers probably crushed. the broad-based market, right, in terms of safety and total return over the following decade. And from 2008, because the problem with 2000 wasn't that global corporate profits really got crushed. It was valuations normalized. And in 2008, you know, in the Great Recession, earnings got crushed. And that fundamentally kills your cash flow ability from the dividend. So, you know, I actually don't have the specific date in front of me, but does that theory line up with... exactly what happened in the relative performance of the two categories, Eli? Speaker 2 (14:26) Well, Scott, I think you hit on exactly what I was about to say. You beat me to it. You have the change in multiple versus the actual change in earnings, which, you know, Mindy, I guess the rebuttal would be, you know, if you're blindly picking dividend stocks and only looking at the yield, then yeah, you're going to get hit pretty hard. People would say, oh, this is hindsight bias. But if two thirds of them didn't cut their dividend, I think. you could manage pretty well picking a lot of the stocks that have very clearly maintainable yields. Now, I think where a lot of people might not follow with me is I, for my personal portfolio, the yields that I buy are quite low. So like Microsoft is a large holding my portfolio. Broadcom is a large holding my portfolio. Visa. These are stocks, you know, Broadcom went through a period of time where the yield was two to three percent. Microsoft did as well. But as of right now, the yield is around one percent or lower. But these are stocks because they're growing free cash flow at double digit rates. the dividend grows at a double-digit rate, creates a really strong compounding effect, and those dividends are incredibly safe. I can't speak to everyone because I don't know what stocks people were buying in 2009. I don't know what stocks people are holding now. But in a scenario where earnings pulled back significantly right now, you're right, dividends aren't guaranteed, but these are stocks where the free cash flow ratio is roughly 20 to 30%. We would have some