The Passive Alternative – Part 3

The big idea and why it matters: Higher-Yielding Dividend Growth stocks create a mathematical mechanism that a) helps savers benefit from price volatility and b) provides spenders (aka retirees) a consistently growing livable wage that is detached from current market conditions; thus, they are a core wealth management tool with far greater utility than passive indexing.

“When the facts change, I change my mind. What do you do, sir?” – John Maynard Keynes (economist).

Sources such as this one leave little room for doubt that Keynes should be credited with today’s quote; however, going down this Quote Investigator rabbit hole finds that Keynes merely expressed a similar idea in 1924 (with different phrasing). Paul Samuelson had a stronger match to the exact wording in 1970, which he attributed to Keynes anyway. So, I guess we can give Keynes the benefit of the doubt and move on with our lives.

Regardless, the quote is one of the greats and very relevant to today’s topic, as we wrap up our discussion on Higher-Yielding Dividend Growth (HYDG) investing and why I believe passive-index equity investors should reconsider the core tenets of their wealth management philosophy. It’s not something to be taken lightly, so today we’ll spend most of the time synthesizing the evidence from Part 1 and Part 2 for greater meaning and pragmatic takeaways. Here we go!

A small (cap) aside, before we really get into it

In Part 1, we also discussed the Fama-French factors and the recent challenges associated with small-cap stocks. I thought this quote from David Bahnsen in a recent Dividend Café summed up the small-cap dilemma nicely and is worth sharing:

At this point, the contrarian in me has no doubt that a day of vindication is coming for small caps, but the exhaustion in this underperformance to big caps behind this extended multi-year period is pretty amazing. There is almost no attention being given to the space; flows are abysmal, and valuation deltas are absurd. But when it all reverses is anyone’s guess.

To David’s point, maybe small-caps will still win out over the long run, but can small-cap evangelists maintain the financial and emotional solvency to wait out that (potential) day of reckoning? Probably not. The same is true for low-yielding (or non-yielding), volatile stocks in general. The game of wealth isn’t just about long-term returns; it’s also about utility and survival along the way on the road to those returns.

What we’ve learned thus far in this series

1. Dividend Growers (i.e., companies that consistently grow their dividends) have exhibited outperformance of the S&P 500 (aka “the market”) over time.
2. It is basically a coin flip whether Dividend Growers or the market will outperform in a given year.
3. For a given level of total return, the composition of income (yield) vs. price appreciation has a significant mathematical impact on both long-term income and return (see the numerical example in Part 2).
4. Given #3, it’s not enough to merely focus on Dividend Growth stocks but rather Higher-Yielding Dividend Growth (HYDG) stocks to target the income and compounding attributes we are seeking.

Practical application

First, if I believe that passive index investing is a good strategy, then I should also think that owning a subset proven to outperform that index (e.g., Dividend Growers as a subset of the S&P 500) is a better strategy. If I then focus on a group of Dividend Growers that collectively offer a higher yield while still maintaining high quality and reasonable valuations, the math of the long-term income compounding and growth trajectory is on my side. Simple, right? So, why doesn’t everyone invest this way?

There are several possible answers:

1. Lack of awareness. I’d imagine this applies to most investors; they haven’t heard of Dividend Growth, or otherwise aren’t sure of what it is or how it works.
2. Lack of belief. It’s 2025, and there are still people walking among us who believe the Earth is flat. With that as our societal benchmark for idiocy, despite ample evidence of the merits of Dividend Growth investing, people will believe what they want to.
3. Lack of understanding (and FOMO). If an investor is not well-grounded in their investment philosophy and then has to endure periods where the market is significantly outperforming their strategy, it can be emotionally challenging. And the fear of missing out on investments we hear about from friends is a real thing. However, as we’ve shown, HYDG accumulators can actually embrace volatility, allowing them to reinvest dividends at lower prices, tune out the noise, and stay the course.
4. Lack of Access. Good HYDG strategies don’t grow on trees, and these aren’t something an investor will likely stumble upon without actively seeking one out. Fortunately, we know where to find a solution.

The tax tale

Many investors come to us with significant unrealized gains in their portfolios that have developed due to general index returns since the Great Financial Crisis (the S&P 500 is up 434% over the past 15 years) or from owning some of the Mag 7 companies, whose outsized performance has pushed market concentration to extreme levels. Congratulations to those who find themselves in that situation, but buying a stock without a plan for an eventual exit strategy isn’t quite disciplined investing.

Rather than moving on from these investments because of excessive valuation levels, these investors now find themselves handcuffed by tax implications and often “let the tax tail wag the investment dog.” Don’t let yourself get figuratively handcuffed by the IRS (as a general PSA, you should also aspire not to get literally handcuffed by the IRS).

A disciplined strategy can still be “tax aware,” but will ensure gains are appropriately taken along the way, avoiding the above-described tax quagmire. As a bonus, the process of trimming and/or selling positions properly during favorable market periods is a significant part of what helps mitigate downside risk in volatile periods. In other words, the discipline itself is part of what makes the strategy create and protect wealth over time.

So, what is “Passive” good for?

The major takeaway from this miniseries is that Passive Indexing may not be the best approach to growing the core of one’s wealth. However, I’m a big fan of employing passive strategies in other aspects of financial planning and investing, and here are a couple of ideas on that front:

• Employer plans and direct deposit splits: Do you know the easiest way to save money? Don’t ever let the money hit your checking account. Many people utilize payroll deductions to fund 401(k) plans, 403(b) plans, or other employer-sponsored retirement plans. But did you know that payroll services can also often split direct deposit amounts across multiple accounts? For example, a $ 5,000 paycheck could be set up to allocate $ 1,500 to a mortgage escrow account, $500 to a brokerage account, and $250 to a donor-advised fund, with only the remaining $ 2,750 being deposited into your checking account after these commitments are automatically fulfilled. Out of sight, out of mind.
• Real Estate and other Alts: As we discussed last year in Let’s Be Real, if you don’t know what you’re doing when it comes to owning or managing real estate or other alternative investments (e.g., private equity or private credit), then I strongly suggest doing it passively. That is NOT the same as saying to invest in these things via an ETF. Instead, hire a good active manager and outsource the workload; these strategies require a massive amount of time, effort, relationship management, and expertise. Dabblers beware.

And there you have it. Higher-yielding Dividend Growth is the sensible alternative to the Passive-Indexing craze.

Until next time, this is the end of alt.Blend.

Thanks for reading,

Steve