Should you choose a dividend stock investment strategy or opt to invest in index funds? In this piece, we’ll take a look at the definition of dividend stocks and index funds, list the pros and cons of both and how to choose between one or the other.
By the time you’ve finished reading, you’ll have a better idea of the type of investment strategy that may work best for your particular goals, investment timeline and horizon.
As you read through the article, go beyond share price and consider which option “sounds” like it’s right up your alley. Let’s take a look at dividend stocks vs. index funds.
What Are Dividend Stocks?
Dividend stocks are stocks of companies that make regular distributions to their shareholders. These usually come in the form of cash payments, though it is possible to receive dividends through additional shares of stock through a dividend reinvestment plan (DRIP). You may also receive special dividends, which are an additional payout and may occur if a company is enjoying more financial success than usual. Companies may also offer real estate — property dividends — as payouts or give you a choice between receiving cash or company stock through a scrip dividend.
Here’s a simple example of how dividend stocks work. Let’s say a company will pay you a dividend of 80 cents per share. If you had purchased 100 shares of that company's stock, you would receive $80 in cash.
Examples of dividend stocks include: 3M (NYSE: MMM), AbbVie (NYSE: ABBV), Chevron (NYSE: CVX), Lowe's Companies (NYSE: LOW) and Walgreens Boots Alliance (NASDAQ: WBA).
What Are Index Funds?
Index funds follow a benchmark index (a group or basket of securities or other financial instruments), such as the S&P 500 index or the Nasdaq 100, that measure and represent the performance of a specific market. In short, they mirror the holdings of the index they track.
When you invest in an index fund, you invest in the companies that make up that index, which gives you a more diverse portfolio than if you planned to buy individual stocks.
Over time, the S&P 500 has historically generated about 10%, according to Macrotrends.
Where did index funds get their start? John Bogle, the founder of the Vanguard Group, changed the idea of investing in mutual funds forever by bringing about index investing by creating mutual funds that track indexes.
Here are some examples of index funds: Vanguard Dividend Appreciation Index Fund ETF (NYSEARCA: VIG) and Vanguard High Dividend Yield ETF (NYSEARCA: VYM). Other brokerages, such as Fidelity and iShares, also offer various types of index funds. Your brokerage will likely offer a wide variety of investment options, so check into the allocation and performance before you dive into investing.
Pros and Cons of Dividend Stocks vs. Index Funds
Let’s take a quick look at the pros and cons of dividend stocks and index funds, separately.
Pros of dividend stocks:
- Produce cash flow: The benefit of dividend stocks is that they produce dividends on a regular basis. Some companies also increase dividends as companies grow and net income increases and provide long-term investment growth.
- Perform during tough times: During inflationary periods, recessions or pandemics, you’ll find that dividend producing stocks usually stand the test of time. In other words, they make money during these periods due to the inherent strength of the product or service they provide. Dividend stocks, particularly those of the Dividend Aristocrats or Dividend Kings, the cream of the crop of dividend stocks, will usually still shell out dividends.
- Can have tax advantages: There are two types of dividends: non-qualified dividends and qualified dividends. Qualified, or ordinary dividends, are taxed at the “better” capital gains rate — 0%, 15% or 20%, depending on your tax status. The tax rate on nonqualified dividends is the same as your regular income tax bracket. In both cases, people in higher tax brackets pay a higher dividend tax rate.
Cons of dividend stocks:
- Tax inefficiency: Even if you hold them for longer than one year, you’ll still pay taxes on dividends, which can hurt your investment returns.
- Can invite risk: You may have heard about the “safety” of investing in dividend funds. However, investing in individual stocks (even if they are dividend-paying stocks) is always riskier than diversifying your portfolio. Diversification means spreading your investments out across many different types of investments all at once. You can still lose money with dividend stocks.
- High payouts can be misleading: In some situations, you may calculate the dividend payout ratio and determine, “It’s really high — how great!” However, when a company has a too-high dividend yield to be sustainable, a company might have to cut their dividend or eliminate it altogether.
Pros of index funds:
- Low fees: One of the reasons investors flock to index funds is their low-cost benefits. Since index funds are passively managed, which means that they employ no middle managers like actively managed funds, expense ratios can generally stay low.
- Broad market exposure: Investing in a broad number of sectors and companies (called weightings) is automatic with index funds. This means that you have automatic exposure to these sectors and companies.
- No heavy lifting: Since you don’t have to research and analyze many types of stocks like you might with dividend investing, you can simply invest in an index fund with a flick of the “buy” button.
Cons of index funds:
- Less flexibility: Index funds will march alongside an index, which can constrain your investment choices. If you invest in actively managed funds, your money manager may buy or sell into different types of securities to gain you an edge. In short, index funds don’t give you much reactive opportunities when you invest.
- Can’t beat the market: You can’t beat the market (or collect higher returns, at any rate) because you’re stuck collecting exactly what the index funds can return.
Choosing Between Dividend Stocks vs. Index Funds
What are the benefits of choosing between dividend stocks vs. index funds? Let’s take a look at several reasons to choose dividend stocks vs. index funds.
The Case for Dividend Stocks
If you’re thinking about investing in dividend stocks, you may want to do so if you prefer:
- Control: If you want control over your investments and want to have the best dividend income strategy possible, you may opt for dividend stocks if you like choosing your own stocks, prefer to have control over your investments (and want to manage them as well) and want to control your dividend portfolio in relation to taxable events.
- To monitor your own performance: If you prefer to monitor your investments over the short term or long term, you may want to choose dividend growth.
- A defensive approach: If you prefer steady investments (investments that weather market corrections and volatility in the market, you may want to opt for dividend stocks due to their defense during market sell-offs.
- Cash flow: If you want a strategy to meet immediate cash needs for day-to-day living, particularly if you’re in retirement and would like to live off the total returns of these dividend investments.
The Case for Index Funds
If you’re thinking about investing in index funds, it can be a great investment strategy. Take a look at a few reasons why you might want to invest in index funds. You may want to invest in index funds if you:
- Are satisfied with matching market performance: Index funds are also best for those who are satisfied with matching the exact market performance. However, if you want to go far beyond the typical payouts offered by index funds tracking the stock market, you may want to bypass index funds altogether.
- Prefer a set-it-and-forget-it strategy: On the other hand, if you want a diversified portfolio with a set-it-and-forget-it wealth management mindset, you may want to choose index funds that track a market index.
- Want instant diversification: If you like the idea of instant diversification, you may want to consider investing in an index fund through a brokerage account.
Are there other benefits to both dividend stocks and index funds? Of course! However, no investment is perfect and you could lose money no matter how you invest.
Are Dividend Stocks Better than Index Funds?
The biggest point to understand: Both dividend investors and index fund investors can benefit from dividend payments and/or index returns. You can invest in a wide variety of options, from exchange-traded funds (ETFs), growth stocks or other trending U.S. stocks or wealth management options.
In short, there’s no “better” investment when it comes to dividend stocks or index funds. Ultimately, it comes down to your preferences, your goals, time horizon, your risk tolerance and other specific needs. If you want to save money alongside your IRA or add this investment approach, your financial advisor may offer some great investment advice. It’s important to remember your overall goals before you choose any type of investment approach, whether you choose to invest in individual dividend stocks or index funds.