Learn the stock market in 7 easy steps. Get spreadsheets & eBook with your free subscription!

Reader Question about Index Funds

I received a question from one of my readers @Rockin_RonE:

“I’m curious about your thoughts on doing your own market research vs. putting money in an index fund. One perk of doing your own research and what not is only investing in companies that pay dividends. Not sure if an index fund primarily focuses on that.”

Ronny, thanks for the great question.

Before I answer it, I think my readers should know what an index fund is. An index fund is a fund that holds a portfolio of companies, usually tied to an index like the S&P 500 or the DJIA. You’ll see common indexes such as the S&P 500 on any stocks app, and referred to on TV.

index fund

An index is just a group of companies. The S&P 500 is also known as the Fortune 500, and is comprised of all the top 500 companies in the United States by market capitalization. The DJIA (Dow Jones) comprises of the top 30 industrial companies, and so on.

Now you can’t just buy the S&P Index straight up, but you can buy an index fund that holds all of the companies in the index through an ETF.

What’s an ETF?

Well it works just like a mutual fund, in the sense that you can hold a basket of stocks. However an ETF is often better than a mutual fund because the fees are much cheaper, due to no management fee.

The ETF will hold all the stocks in an index, and will get a return based on how well those companies do. The price of the ETF then goes up or down like a stock, but it depends on the performance of the stocks it holds.

Index Fund Advantages

So, what you can do is buy an index fund ETF such as $SPY, and suddenly you own a part of all the companies in that index (in this case the S&P 500).

This is great for investors in several ways. 

For starters, it’s a quick way to get diversified. Owning 10 stocks is much less risky than owning 1 stock, and with an ETF like $SPY, you’ll own 500 stocks which is much less risky than owning 10 stocks.

Also, an index fund ETF allows you to participate in many of the gains of a general bull market, without having to know much about stocks. You can buy an ETF like $SPY and just hold for the long term, and you will do very well for yourself.

However, there are some downsides to index fund ETFs. That is, the returns of an ETF tend to be lower than individual stocks.

Risk and Reward are Tied

You might have heard the saying: no risk, no reward. It’s true in the stock market, and it’s true with index fund ETFs.

If you are confident in your ability to learn how to pick stocks, then maybe index fund ETFs aren’t right for you. If you are happy with average returns and don’t want to do much work, ETFs are perfect.

Just because you want to go for higher gains doesn’t mean you don’t have to use index fund ETFs. In fact, it can make for a good balance, to have some index funds and some individual funds. Ultimately, it’s all up to you. The risk tolerance of every investor is different.

That all being said, I personally use index ETFs for some of my portfolio, but I focus on my individual holdings. I’m confident in my ability to achieve higher returns and yields, and it’s precisely because I’ve educated myself.

I don’t keep these secrets all to myself, and you can read about them by subscribing. I’m confident that if you want to chase higher returns also, you can do it with my help and my recommended resources. But you mustn’t be lazy, at least in the beginning.

Finding Success with Dividends

The reason behind my preference for individual stocks lies in my ability to find higher returns and yields. To answer part of your question Ronny, many ETFs do pay a dividend, but pay a low percentage such as 1 or 2%.

I’m always trying to find dividend yields of at least 3 – 4%, if I can. Contrary to what some people think, you can still get growth with a high dividend yield.

Take Corning for example, $GLW. When I bought the stock, it was trading at $12.65 with a 3% yield. I knew I couldn’t get that kind of yield with an ETF, so I bought the stock. Today it is trading around $19.50, but I’m planning on holding even longer.

You see, a good dividend growing company like Corning will pay a higher dividend each year, and these are the types of companies I like to buy. I’ll be getting a $0.39 dividend this year, which is about 3% of $12.65– the price I paid for that yield. But Corning has been growing its dividend, and expects to continue that growth.

So maybe in 5 years time the dividend will be at $0.78 or so (assuming 20% div. growth). Then I’ll be getting 6% yield for what I originally paid. Not only that, but all the dividends before then will have been collecting and compounding as well. In another 5 years it should double again, and again and again. This is how true wealth can be made from a smart investment.

Index ETFs don’t typically have this same time of strong dividend growth. Because so many companies make up an index, many of them aren’t able to maintain a strong financial position.

It may seem minimal at first, but over time the differences can really compound.

Some ETFs actually specialize in high dividend paying stocks, with some yields I’ve seen being even as high as 6%. But there’s a downside to these as well.

Many of the really high dividend payers aren’t sustainable. Just because a stock is paying a high dividend doesn’t mean that the company is strong financially.

The Key is Sustainable Growth

The key is to find sustainable dividend growth. Honestly, it’s not easy to find and you won’t stumble into it with an ETF. Take a look at any high dividend ETF like $DWX. Their dividend payouts are all over the place. It doesn’t grow nicely like a strong company does.

Also, a lot of the high dividend payers sacrifice growth. Many of these don’t see as big returns as the rest of the market. I won’t accept that.

Again take $DWX as an example. Sure, it pays a high dividend yield, but from the lows of 2009 to today, the share price went from the $25 range to about $48. That’s only a 98% return.

Compare that to the S&P 500? The S&P went from about $600 to more than $1800 in the same time period, a return of almost 200%!

Compound those kind of returns over the lifetime of an investor, and you are talking about thousands to hundreds of thousands of dollars being missed out on.

I’m confident in my ability to beat the S&P 500 over the long run. For me, it’s not about winning in the next 6 months or year. I have a 40 year perspective.

I have the patience of a tortoise. I know my methods will win out in the long term, and I’m not afraid to defend it. Many people love index funds, and it might be right for you.

For me, I’m avoiding the risky stocks. I’m investing in the strongest companies, with the fiercest balance sheets and most reliable dividend payouts. I’m getting growth, but paying value.

I’m in it to win.

**Reader Question about Index Funds**
**All Rights Reserved. Investing for Beginners 2013**
**Photos shown above can be found: Photo Attribution**