Summary

• Investors frequently compare their past returns to the past returns of the market.
• Past returns are no guarantee of future returns.
• The historical real return from dollar cost averaging into the market has been fairly consistent.
• To outperform the market going forward, it seems reasonable to select stocks that have a high probability of beating these historical real returns.
• Dividend growth investing provides an opportunity to beat the market going forward.

Indexing vs. other strategies

There have been several articles on Seeking Alpha lately attempting to answer the question of whether dividend growth investing beats a passive index strategy in total return. In this article. for example, the author points out that the SPDR S&P 500 ETF Trust (NYSEARCA:SPY ) has compounded at an annualized rate of 15.67% for the last five years, while most dividend growth portfolios have not. Aside from whether this is a cherry-picked time frame (it starts at the beginning of the current bull market, just after SPY fell much further than most dividend growth stocks did, for instance), it is not particularly relevant to our current needs as investors in that it provides no reasonable expectation about future returns.

As a young investor, my primary goal is accumulating enough assets to fund my eventual retirement. I identify as a dividend growth investor because I feel that the dividend growth strategy gives me the highest chance of achieving my goals, but I cannot deny that an investor who earns a higher total return during the accumulation phase is better positioned going into retirement regardless of what strategy is used to obtain that return. Nevertheless, I believe that intelligently executed dividend growth investing has a reasonable chance of outperforming the market going forward, and in this article I lay out why.

To do so, I will do the following two things.

1. First, I will explain what I expect the future market returns to be over a long time span.
2. Second, I will show how intelligently selecting dividend growth stocks gives a high probability of beating these returns.

Future market returns from past market returns, 1928-2014

I think the best way to predict the future is by studying the past. Since I am going to make many investments over the course of many years leading up to my retirement, and since inflation distorts market values and investment results, I am most interested in knowing what the historical real (inflation-adjusted) market returns from dollar cost averaging over long time periods (20+ years) have been. However, I was not able to find any information about this on the internet, so I have been forced to do the calculations myself.

Historical 1-year nominal stock market returns (price change + dividends) since 1928 can be found here .

The real return from dollar cost averaging into the market

Suppose an investor dollar cost averaged into the market over a long time period (20 years or more), what would his/her real (inflation-adjusted) returns have been?

To answer this question I looked at three different dollar cost averaging scenarios intended to mimic how real people invest, over every 20+ year stretch from 1928 to present.

1. Scenario 1: The investor invests a constant amount of money (say $5000) each year.
2. Scenario 2: The investor invests $5000 during the first year and varies the amount invested each following year according to the inflation rate. If the inflation rate from year 1 to year 2 is 10%, for instance, in year 2 $5500 is invested. On the other hand if the inflation rate from year 1 to year 2 is -10% (that is, 10% deflation), then in year 2 $4500 is invested instead.
3. Scenario 3: The investor invests $5000 during the first year and varies the amount invested each following year according to the inflation rate, except that he never increases his contribution by more than 5% from one year to the next. (The idea here is that it is difficult to keep up with high inflation.)

Surprisingly, the results were virtually identical for all three scenarios, so I’ll only record here the results from Scenario 1. For market returns, I used the link above, and for inflation, I used the government’s official cpi-u data. Here are the results.

Table 1: Annualized real return (as a percentage) from dollar cost averaging into the market for N years, starting in year Y