Is it better to buy individual dividend stocks or ETFs?
Dividend ETFs can be a good option for investors looking for a low-cost, diversified and reliable source of income from their investments. Dividend stocks may be a better option for investors who prefer to choose their own investments.
Stock-picking offers an advantage over exchange-traded funds (ETFs) when there is a wide dispersion of returns from the mean. Exchange-traded funds (ETFs) offer advantages over stocks when the return from stocks in the sector has a narrow dispersion around the mean.
One downside to investing in stocks for the dividend is an eventual cap on returns. The dividend stock may pay out a sizable rate of return, but even the highest yielding stocks with any sort of stability don't pay out more than ~10% annually in today's low interest rate environment, except in rare circ*mstances.
Disadvantages. However, dividend ETFs are not without pitfalls. One of the tradeoffs for consistent income and lower risk is frequently a lower potential for growth. Companies that regularly pay out dividends tend to be more conservative in reinvesting profits for expansion.
Historically, dividend growth companies have outperformed the broader S&P 500 index and provided durable income growth across market caps and industry sectors.
The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.
If you don't want to put a lot of effort into managing your investments, then S&P 500 ETFs are a good solution. But if you're willing to do the work, then you might do even better in the long run with a portfolio of hand-picked stocks (although, the odds are against you).
An ETF can stray from its intended benchmarks for several reasons. For instance, if the fund manager needs to swap out assets in the fund or make other changes, the ETF may not exactly reflect the holdings of the index. As a result, the performance of the ETF may deviate from the performance of the index.
The risks are too great with individual stocks
Financial pros like Benz urge investors to build broadly diversified portfolios for a reason: While the overall historical trajectory of the stock market has trended upward, any individual stock has a chance to decline sharply in price and destroy your portfolio's returns.
To generate $5,000 per month in dividends, you would need a portfolio value of approximately $1 million invested in stocks with an average dividend yield of 5%. For example, Johnson & Johnson stock currently yields 2.7% annually. $1 million invested would generate about $27,000 per year or $2,250 per month.
Is it smart to only invest in dividend stocks?
As part of a diversified portfolio, dividend stocks have their place. They offer relative stability, may pay increasing amounts over time and may provide steady income. But relying too heavily on dividend stocks as a primary investment approach could put you at risk and reduce your long-term investment gains.
Dividend ETF | AUM | Expense Ratio |
---|---|---|
Vanguard Dividend Appreciation ETF (VIG) | $74 billion | 0.06% |
Vanguard High Dividend Yield Index ETF (VYM) | $51 billion | 0.06% |
Schwab US Dividend Equity ETF (SCHD) | $52 billion | 0.06% |
Global X SuperDividend ETF (SDIV) | $738 million | 0.58% |
For most personal investors, an optimal number of ETFs to hold would be 5 to 10 across asset classes, geographies, and other characteristics.
Ticker | Name | Annual dividend yield |
---|---|---|
DIV | Global X SuperDividend U.S. ETF | 7.06% |
SPYD | SPDR Portfolio S&P 500 High Dividend ETF | 4.67% |
SPHD | Invesco S&P 500® High Dividend Low Volatility ETF | 4.52% |
FDL | First Trust Morningstar Dividend Leaders Index Fund | 4.51% |
Dividends Are Not Capital Gains or Income
Dividend income is unusual in that it has typically already been taxed (corporations pay taxes on the income that they then use to pay dividends), but that does not shield it from additional taxation.
Stock | Dividend yield* |
---|---|
3M Co. (MMM) | 6.5% |
Kinder Morgan Inc. (KMI) | 6.6% |
AT&T Inc. (T) | 6.7% |
Verizon Communications Inc. (VZ) | 6.7% |
Whether you want to live off dividends today or are investing for the long haul, the best way to build a dividend portfolio for steady income is to follow a simple set of risk management principles: Hold between 20 and 60 stocks to reduce company-specific risk. Roughly equal-weight each position.
ETFs may close due to lack of investor interest or poor returns. For investors, the easiest way to exit an ETF investment is to sell it on the open market. Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF.
In fact, 47% of all such funds have closed down, compared with a closure rate of 28% for nonleveraged, noninverse ETFs. "Leveraged and inverse funds generally aren't meant to be held for longer than a day, and some types of leveraged and inverse ETFs tend to lose the majority of their value over time," Emily says.
For most standard, unleveraged ETFs that track an index, the maximum you can theoretically lose is the amount you invested, driving your investment value to zero. However, it's rare for broad-market ETFs to go to zero unless the entire market or sector it tracks collapses entirely.
Why not just invest in the S&P 500?
Perhaps the biggest downside of an S&P 500 index fund is that it can only earn average returns. This type of investment is designed to follow the market, so it's simply not possible for it to beat the market. For many people, lower returns are a worthwhile trade-off for the ease and simplicity of an S&P 500 index fund.
That being said, while investing only in the S&P 500 is better than trying to beat the market, it is still not good enough to achieve optimal diversification. This strategy guarantees that the investor will be exposed to undiversified risk that has been proven to lead to substantial financial loss.
ETFs can be safe investments if used correctly, offering diversification and flexibility. Indexed ETFs, tracking specific indexes like the S&P 500, are generally safe and tend to gain value over time. Leveraged ETFs can be used to amplify returns, but they can be riskier due to increased volatility.
Interest rate changes are the primary culprit when bond exchange-traded funds (ETFs) lose value. As interest rates rise, the prices of existing bonds fall, which impacts the value of the ETFs holding these assets.
Exchange-traded fund (ticker) | Assets under management | Yield |
---|---|---|
Vanguard 500 Index ETF (VOO) | $406.2 billion | 1.4% |
Vanguard Dividend Appreciation ETF (VIG) | $75.6 billion | 1.9% |
Vanguard U.S. Quality Factor ETF (VFQY) | $298.0 million | 1.4% |
SPDR Gold MiniShares (GLDM) | $6.1 billion | 0.0% |
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