There are many individual retail investors out there that compare their portfolio’s performance to a benchmark like the S&P 500 – a collection of 500 publicly traded companies selected by market weight, industry, liquidity and other factors. Generally speaking, the S&P 500 is a widely used bellwether for the overall U.S. stock market and an indicator of business in general. For all intents and purposes, the S&P 500 is “the market” – and so when you hear about people “beating the market”, they’re usually referring to beating the S&P 500.
However, I don’t use the S&P 500 as a benchmark for which to compare my portfolio’s performance to. And I’ll tell you why.
I’m a dividend growth investor. By that I mean I typically invest only in companies with longstanding track records of rewarding shareholders with continuously increasing dividends. That’s definitely not the only basis that constitutes my investment strategy, but it’s certainly a cornerstone. I look for high quality companies with durable economic moats (including recognizable brand names, economies of scale, global distribution networks, etc.), healthy balance sheets, strong free cash flow, low payout ratios, rising revenue and earnings, competitive advantages, histories of operational excellence and great management. Furthermore, I look to purchase shares in these high quality dividend growth stocks at prices below their intrinsic value – a value that’s determined to a reasonable degree of accuracy through fundamental quantitative and subjective qualitative analysis.
This is something I repeat over and over again. And I’ve repeated these steps over and over again to the point that I now have a six-figure portfolio with shares in 43 high quality companies. This portfolio generates almost $5,000 in annual dividends right now, which is a great start on my way to my overarching goal of exceeding my annual expenses with dividend income. I’m 31 years old now, and my goal is to become financially independent – with the option to retire from work forever if I want to – by 40 years old. My expenses teeter around the $20,000 mark on an annual basis, so I’m about 1/4 of the way there.
Seeing as how my ultimate goal in life is to become financially independent by 40 years old via passive income generation through dividends, my attention naturally finds itself spent on monitoring my dividend income, companies’ policies regarding dividends, payout ratios, annual dividend raises by the companies I’m invested in and companies I’m interested investing in, etc.
However, my attention is never diverted toward comparing my portfolio’s total return against the total return of the S&P 500. Why? Because my ability to one day live completely off of the dividend income my portfolio generates has nothing to do with the performance of the S&P 500, or my portfolio’s performance against it.
Think about that for a second, because if you’re also interested in one day reaching financial independence in a similar manner to myself you’ll want to consider whether taking the time to compare yourself against an arbitrary benchmark is really the best use of your limited time and resources.
Put another way, my dividend income will one day pay for expenses like rent, utilities, food, gas, entertainment and travel. When The Coca-Cola Company (KO) or Philip Morris International (PM) deposits dividend payments into my brokerage account, I’ll one day withdraw that capital and use it to pay my through life. I’m currently reinvesting 100% of this income, but that will change when I’m done accumulating assets and living off the income those same assets provide. Now what would the S&P 500’s performance have to do with my ability to purchase food or pay for rent? Nothing.
In fact, I would say that comparing your performance against the S&P 500 can be dangerous and deceiving.
Let’s explore that concept a bit.
Let’s say the S&P 500 is down 30% for the year and you find that your dividend growth portfolio is down 31% YTD. Have you really “lost” anything? Would you have won some kind of prize if you were only down 29% for the year? No and no. Furthermore, the total return index investor who’s relying on the 4% rule and selling portions of their portfolio to pay for the aforementioned rent and food might be in dire straits as the underlying assets they’re selling off have declined significantly in price and may leave them in a position to where it’s impossible to continue meeting current obligations without bleeding their portfolio dry. I instead look at my portfolio as a tree where I pluck the fruit the branches produce instead of hacking off the branches, slowly killing the tree one cut at a time.
So you can beat the S&P 500, but if you can’t afford to pay your bills that doesn’t mater very much. It won’t get you very far to tell your landlord or bank holding your mortgage that while your portfolio took a beating and it’s tough to come up with the cash to pay the rent/mortgage, you beat the S&P 500 by two percentage points.
Put another way, if after twelve years of investing I outperformed the S&P 500 on a cumulative basis but failed to build my passive income to a level that was sufficient to pay for all of my expenses I’d consider my journey a failure. Outperforming the S&P 500 doesn’t pay the bills, but dividend income does. Outperforming the S&P 500 doesn’t win you prizes, but attaining financial independence wins you the biggest prize of all: time.
I focus on what matters to me and my ability to one day live off of passive dividend income. This means focusing on quality and value. I regularly research companies I’m currently invested in and companies I’m interested in investing in for dividend payment health and the reasonable likelihood of continued dividend growth. I focus on reducing my expenses as much as possible so that I can save more than 50% of my net income, thereby giving myself the most ammunition possible with which to purchase high quality equities on a regular enough basis so that my dividend income is exponentially growing constantly. I may not load up an elephant gun like Warren Buffett with the type of ammunition I’m working with, but I can do a lot of damage with a pea shooter over a decade.
However, even though I don’t focus on trying to beat the S&P 500 that doesn’t mean I’m not interested in total returns. I am. But what I find is that high quality companies that have such wonderful brands, such ingrained systems and services and such profound records of operational excellence that allow them to raise dividend payouts for years or decades on end tend to do pretty darn well over the long haul. Furthermore, because many of these companies – like Exxon Mobil Corporation (XOM) or Johnson & Johnson (JNJ) – tend to have a low beta (a measure of a stock’s volatility against the market as a whole) I usually experience less of the dramatic ups and downs of the broader market. I tend to see my portfolio rise a bit less when the market is up and fall a bit less when the market is down. And as a final point, while I surely appreciate a solid risk-adjusted return over a long period of time I rather look forward to seeing shares in the high quality companies I’m interested in or already invested in decline in price because it allows my fresh capital to buy more shares, and hence increase my dividend income at a more rapid pace. More shares buys more dividends, and more dividends means greater reinvestment ability.
As always, I recommend focusing on what you can control. I constantly reiterate to let go of fear and greed and all of the emotions that will lead you astray as an investor. As an extension of that advice I also recommend to refrain from comparing yourself to some benchmark that someone else manufactured. This goes for the S&P 500 or any other collection of equities out there.
I could fail to outperform the S&P 500 for every single year of my investment career and still succeed as an investor – because my definition of success is being able to claim complete financial freedom by the time I’m 40 years old. And which sounds better to you – bragging rights or freedom? I’ll take the latter.
How about you? Do you compare your performance to a benchmark?
Full Disclosure: Long KO, PM, XOM, JNJ
Thanks for reading.
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