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Should You Invest in Dividend Stocks, ETFs, or Mutual Funds? What to Consider

Investments can help you grow wealth in many ways. One way that you may have heard of is dividends.

It is very similar to earning interest on a savings account.

Some people like to focus on dividend income while others make dividend investments part of their overall portfolio.

Learn what is dividend investing and how you can incorporate this type of investment in your very own portfolio.

What is Dividend Investing?

There are two ways investors make money on stocks.

  1. Capital appreciation: Essentially, capital appreciation is the growth in price investors expect after purchasing a stock.
  2. Dividends: That’s the annual yield a company pays on its stock to its stockholders.

Dividend investing is essentially income investing, while capital appreciation is a play on growth.

The best part:

It is possible for a high dividend-yielding stock to provide both income and capital appreciation.

A dividend-paying stock is essentially any stock that pays a dividend (many do not).

But to the typical investor, a discussion of dividend stocks refers to those that pay above-average dividend yields.

One possible measure of a dividend stock is if its dividend yield (the annual dividend divided by its stock price) in comparison to the dividend yield on the S&P 500 index.

Since the dividend yield on the index is currently hovering around 2% any stock paying a higher yield is likely to qualify as a dividend stock.

There’s a more technical definition, however.

A dividend stock is one in which the issuing company pays a substantial percentage of its profits in dividends to stockholders.

By contrast:

A growth company is one that pays little or no dividends to stockholders, reinvesting all profits back into the company for growth.

Dividend investing involves creating a portfolio comprised of various high-yielding stocks, providing a diversified and steady stream of stable income.

Dividends are typically paid on a quarterly basis.

For example, a company that pays an annual dividend of $1 will likely issue those dividends at a rate of $.25 per quarter.

Types of Companies that Tend to Issue Dividends

Dividend stocks can be found in any industry, but they are more common in some industries than in others.

For example, while they’re fairly rare among high-tech companies, they’re quite common among utilities, banks, and real estate investment trusts (REITs).

Examples of such companies (and their respective dividend yields) are:

  • AbbVie, 6.279%
  • Archer-Daniels-Midland Co., 3.655%
  • Franklin Resources, Inc., 3.375%
  • Cardinal Health, Inc., 4.365%
  • Chevron Corp., 3.978%
  • Leggett & Platt, Inc., 3.994%
  • People’s United Financial, Inc., 4.862%
  • AT&T, Inc., 5.803%
  • Walgreens Boots Alliance, Inc., 3.473%
  • Exxon Mobil Corp., 4.824%

Please be advised this is not a recommendation for investment, as we have not analyzed these companies, nor are we qualified to do so. Consult a financial professional for appropriate advice.

How to Invest in Dividend Stocks

There are three primary ways to invest in dividend stocks:

Individual dividend stocks

Investing in individual dividend stocks involves stock picking.

It’s best reserved for those who have experience successfully choosing individual stocks.

For diversification purposes, you should assemble a portfolio of several companies, which is why stock-picking experience is so important.

If you’re going to invest in dividend stocks, be sure you’re not concentrating solely on dividend yield.

Any yield a company pays on its stock is completely dependent on the fundamental strength of the company.

If a company pays a 5% dividend yield, but has had an overall net loss over the past two years, there’s an excellent chance the dividend yield will be cut. When that happens, the stock price will follow suit, if it hasn’t already.

In the current market environment, a stock yielding 4% is considered a good return if the company is fundamentally sound.

But if you see yields in the 8% to 10% range, it may be a warning sign that the company is in trouble, and about to cut its dividend.

Dividend ETFs

Exchange-traded funds, or ETFs, are funds that provide a diversified portfolio of dividend-paying stocks.

Generally speaking, ETFs represents what is known as “passive funds”, because they track popular stock indexes. That means their performance is tied to the performance of the underlying index.

The ETF neither outperforms nor underperforms the index. And because they’re tied to an index, they tend to have lower expense ratios than mutual funds.

Examples of some of the most popular dividend ETFs include Vanguard High Dividend Yield ETF (VYM), iShares Select Dividend Index (DVY) and Schwab US Dividend Equity ETF (SCHD).

Dividend mutual funds

Dividend mutual funds work like ETFs in that they are portfolios of many different dividend-yielding stocks.

The main difference between the two is that mutual funds are typically actively managed, which is to say they try to outperform the market.

In reality:

This rarely happens.

Most mutual funds underperform the market. Mutual funds also come with higher fees than ETFs, which cuts into your long-term investment return.

Examples of popular dividend mutual funds include Fidelity Equity Income Fund (FEQIX) and Vanguard Equity Income Investors Shares (VEIPX).

Once again, please consult a financial professional, as these are examples and not recommendations.

Should You Have Your Dividends Issued as Cash or Automatic Reinvestment?

The answer to this question:

It really depends on your investment objective.

If that objective is to provide current income, you’re better off to take the dividends as cash. But if you’re looking to grow your portfolio of dividend-paying stocks, automatic reinvestment is definitely the way to go.

With automatic reinvestment, which is usually offered by the issuing company through what is known as a dividend reinvestment program (DRIP). Dividends are automatically reinvested into the purchase of more shares in the company.

As an example, let’s say you buy stock in a company paying a 5% annual dividend. After 20 years with automatic reinvestment, you’ll roughly double the number of shares you’re holding in the company.

That will give you a larger portfolio, and ultimately more dividends.

This strategy is best used by those who are investing for the long term, such as for retirement.

Tax Implications

How dividends are taxed depends on whether they are considered qualified or ordinary dividends.

To be considered a qualified dividend, the stock must be:

  • issued by either a U.S. corporation,
  • or a foreign corporation whose stock trades on a US stock exchange.

You must also own the stock for a minimum of 60 days.

Ordinary dividends occur when the company or your investment don’t meet those two qualifications.

If dividends are considered qualified, they’re taxed at more favorable long-term capital gains tax rates.

For example, if you’re in the 12% tax bracket, the dividend income will be tax-free. If you’re in the 22% to 35% tax bracket, your dividends will be taxed at 15%. At the 37% tax rate, the tax on qualified dividends is limited to 20%.

Ordinary dividend income, however, is taxable at your regular income tax rates.

Overall, however, the best way to hold dividend stocks is in a tax-sheltered retirement plan, like a 401(k) or an IRA.

Since both plans are tax-deferred, it won’t matter whether the dividends are qualified or ordinary, or what regular tax bracket you’re in.

Pros and Cons of Investing in Dividend Stocks

Pros:

  • Many dividend stocks pay yields exceeding those offered on CDs.
  • Dividend stocks offer both high-yield and the potential for capital appreciation.
  • The value of dividend stocks can rise when interest rates fall.
  • High-yielding dividend stocks can be more stable than growth stocks in declining markets.

Cons:

  • Dividend stocks can decline in value.
  • Dividend stocks can fall in price when interest rates rise.
  • A company can cut its dividend payment, causing the stock price to fall.

Not a Replacement for Savings Accounts or CDs

Investors need to be aware that dividend stocks are not suitable as replacements for savings accounts or CDs.

There are several reasons why this is true:

Lack of safety

One of the primary reasons for holding at least some of your portfolio in bank assets is because they are completely safe.

You’re guaranteed to receive your original principal investment – plus accrued interest – when you redeem your funds.

What’s more:

Savings accounts and CDs come with FDIC insurance, which is not available for dividend stocks.

Lack of liquidity

If you need to access funds on short notice, it’s much easier to withdraw funds from a savings account, or even make an early withdrawal from a CD.

If you need cash, and your money is tied up in dividend stocks, the stocks will need to be sold.

Not only will take several days for the stock sale to settle, but you may sell the stock for less than your original investment.

Or, if there’s a gain, you may have a tax liability.

It’s also worth noting dividend stock value can’t be accessed through an ATM, the way many savings accounts can.

Not suitable as an emergency fund

This is for the reasons cited above.

The two most fundamental requirements for an emergency fund are both safety of principal and liquidity in the form of quick access to your funds.

Dividend stocks offer neither.

Final Thoughts

Dividend stocks are an excellent addition to just about any portfolio.

Not only do they provide steady income, but if the underlying fundamentals of the issuing companies are strong, they can also provide long-term capital appreciation.

Look:

Just be careful not to mistake dividend stocks for traditionally safe investments, like savings accounts, money markets, and CDs.

Dividend stocks may be similar in that they pay a regular income, but they don’t provide the qualities of safety and liquidity that bank type investments do.