ETFs vs. Dividend Stocks: Which Should You Invest in?

When you’re thinking about investing, what do you prefer to invest in?

If you’ve never invested before, it might be tough to narrow down your options. Two investment opportunities might include exchange-traded funds (ETFs) or dividend stocks.

ETFs are a collection of securities in which you can buy and sell shares on a stock exchange, just like an individual stock. Dividend stocks, on the other hand, are shares of publicly traded companies that regularly share profits with shareholders through dividend payments.

These two seemingly unrelated investing options might fit your needs, but the right type of investment depends on your needs and goals. Whether you’re thinking carefully about getting closer to hanging out with other retirees (maybe you’re retiring in 10 years) or would prefer an income stream to live off (in the form of dividend payouts).

Let’s walk through ETF vs. dividend stocks. What are your investment objectives? Let’s find out.

What Are ETFs?

An exchange-traded fund (ETF) is made up of baskets of securities that could include stocks and bonds and track an underlying index.

Like normal stocks, ETFs have tickers, such as SPDR S&P 500 ETF Trust (NYSEARCA: SPY) or SPDR S&P Dividend ETF (NYSEARCA: SDY), Vanguard Dividend Appreciation Index Fund ETF (NYSEARCA: VIG) or Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD), are listed on stock exchanges like the NASDAQ and can be traded during normal trading hours like stocks. These “baskets of assets” track a specific index. ETFs can help you reduce your risk and exposure because your portfolio automatically has diversification. ETFs can be a good hedge against stock market volatility because of this diversification.

ETFs can include a wide variety of assets, including stocks, bonds, commodities, or currencies. Investors buy shares of that basket, just like buying shares of a company.

How to Invest in ETFs

When you invest in ETFs, it’s much like purchasing a regular stock. You must have a brokerage account to buy and sell ETFs, such as at Fidelity, J.P. Morgan, and other brokerages. It’s important to choose the right ETFs for you, which means taking a look at investment prospectuses, expense ratios, share price, net assets, and past performance. (Just remember that past performance doesn’t guarantee a specific fund’s future performance.) Once you decide on the right type of ETF investment for you, you can place your trade, but don’t forget to keep track of your ETFs as the months and years go on.

What Are Dividend Stocks?

Dividends are payments that companies make to you, the shareholder, based on the number of shares you own. Dividend-paying stocks refer to an investment strategy that can pay out cash dividends or reinvestment of the stocks into more stocks. The dividend yield, which is something that you want to pay attention to, is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price.

The Dividend Aristocrats and Dividend Kings are an example of specific dividend growth of the S&P 500 index. These companies not only pay a consistent dividend to shareholders, but they also increase the size of their payouts. To become a part of the Dividend Aristocrats or Dividend Kings, companies must meet specific requirements. The Dividend Aristocrats raise their dividends consistently for at least the past 25 years. They also must increase their annual total dividend per share for 25 straight years in a row, have a market capitalization of at least $3 billion as well as a daily trading amount of at least $5 million.

The Dividend Kings, on the other hand, may qualify by raising their total dividend per share for 50 straight years.

How to Invest in Dividend Stocks

Dividend investing provides a hedge against inflation because it continually put cash in your pockets, even during times of inflation. Dividend stocks are also tax-advantaged, unlike other types of investments such as interest rates on fixed-income investments. Dividend-paying stocks also tend to be less volatile than non-dividend-paying stocks. The right investment strategy can help you build wealth through dividend income.

You can put money into individual dividend stocks, dividend ETFs or dividend mutual funds. Let’s take a look at these three types of funds.

• Individual dividend stocks: Individual dividend stocks means that you invest directly in an individual company. For example, you may invest directly in Coca-Cola stock.
• Dividend ETFs: A dividend ETF is an exchange-traded fund (ETF) designed to invest in a basket of dividend-paying stocks. The fund manager of a dividend ETF chooses a portfolio of stocks that pays out dividends to investors, thereby working as an income-investing strategy for individuals that purchase the ETF. These are usually low-cost investments that can help you build long-term capital over time.
• Dividend mutual fund stocks: Another type of dividend investment you can take advantage of includes dividend mutual funds, which are mutual funds that invest in stocks that pay dividends. These dividends can either go into purchasing more mutual funds as an income stream, or you can also reinvest dividends of a DRIP plan to buy more of the same stock.

Pros and Cons of Investing in ETFs

Let’s take a look at the pros and cons of investing in ETFs to see whether you can invest in ETFs.

Pros:

• Diversification: ETFs allow you to automatically invest in a range of asset classes and a wide range of companies. This is less risky than purchasing individual stocks.
• Trade like stocks: You can sell your ETF at any point during the day like a stock, unlike mutual funds, that you can only trade once, after the markets close at 4 p.m. ET. Because the ETF trades like stocks, you can take advantage of the immediate liquidity available to you.
• Less expensive to buy: ETFs are synonymous with low cost. For example, the Vanguard High Dividend Yield ETF (NYSEARCA: VYM) has an expense ratio of 0.06%. Fees and expenses should be a large consideration before you invest.

Cons:

• Not always a low cost: Keep in mind that not all ETFs have low expense ratios. Some ETFs are expensive relative to a traditional market index fund. Some new funds have increased to over 0.6% and some ETFs charge 1% in fees compared to the average traditional market index ETFs, which charge about 0.20%, according to Fidelity. Even if your returns are great, the returns you could realize may continually decline due to the fees you’ll pay over time.
• Tracking errors: ETFs don’t always track indexes perfectly and as an investor, tracking errors can cost you in total returns. For example, indexes do not hold cash but ETFs do, so ETF tracking errors are common. Some indexes also hold illiquid securities that the fund manager cannot buy.

There are other pros and cons of investing in ETFs. It’s a good idea to do your research and make sure that you receive investment advice and read through the disclaimers (the fine print) about each ETF you’re thinking about investing in.

Pros and Cons of Investing in Dividend Stocks

Now, the pros and cons of investing in dividend stocks.

Pros:

• Offers consistency: Many dividend stocks offer money that you can regularly depend on and that may increase, particularly among the Dividend Aristocrats and Dividend Kings. You can rely on a passive income stream to help you meet your monthly financial goals or help support you in retirement.
• Hedge against inflation: If you’re looking for a way to beat inflation or poor market performance, dividend stocks do put you at an advantage, because you can depend on dividends in lieu of what’s going on in the market. Many solid companies are insulated against fluctuations in the stock market and still return dividends.

Cons:

What are the downsides of investing in dividend stocks? Let’s take a quick look:

• Investment risk: Put simply, dividend stocks still carry risks, particularly those that aren’t the top dividend stocks. For example, you can invest in bonds, CDs, and other fixed-income assets, dividend stocks carry more investment risk because of the nature of stocks, which are riskier because they aren't diversified at all.
• Dividend fluctuation: Not all companies return the same dividends. Some companies may have to skip their dividends if they don’t make enough during a particular quarter or a merger falls through. If a company finds that its dividend is sustainable, the company may have to shorten the returns or eliminate dividends completely.

There are other pros and cons of dividend stocks to consider, so make sure you review all the possibilities before you invest.

ETF vs. Dividend Stocks: Which is Best for You?

Which option makes the most sense for you — ETFs or dividend stocks?

Take time to study the differences between ETFs and dividend stocks and/or consider which type of option makes the most sense for your specific goals. If you prefer a regular stream of income, you may want to consider purchasing dividend stocks. However, if you want to invest for the future, such as to save for retirement, an ETF may make the most sense for your long-term needs.

Companies Mentioned in This Article: