Dividend Investing: Pick Stocks or Diversify with ETFs?

by Kevin on August 16, 2012

A few weeks ago I broached the topic of dividend investing. Dividend investing has always been one of those things that I thought was neat, but wasn’t sure if it was the best overall strategy.

If you’re going to pursue dividend investing you have several options before you. For me, there are two options that make sense to invest your money in. (I’d love to hear how you dividend invest in the comments.)

Which option would you choose?

Two Strategies for Dividend Investing

Here are the pros and cons of two different strategies for investing for dividend yield.

Pick Individual Stocks

If you target individual stocks that have high dividends you can bump up your returns over what you would get with an ETF that holds 100 different dividend stocks.

Of course this higher return comes at higher risk: a stock may have a very high dividend yield for negative reasons, and putting all of your money into one stock is incredibly risky.

You could pick a bunch of individual stocks to put together your own basket of high dividend paying stocks. You still might expose yourself to higher risk due to less diversification and again, because some stocks have very high dividends for negative reasons. (You might weed out some of the incredibly high yields and just focus on higher than average yields.)

The pros to picking your own basket of individual dividend stocks:

  • You invest in exactly what you want.
  • You can screen for the qualities in a stock that you want and rule out stocks you don’t like for whatever reason.
  • You completely control the companies you are investing in.

The cons to picking your own basket of individual dividend stocks: 

  • You have more exposure to the ups and downs of an individual stock unless you buy a large number of individual stocks.
  • You have to track the stocks you are invested in, watch for bad news, and decide when to buy and sell shares in individual companies.

Pick an ETF or a Basket of ETFs

On the other hand if you are just looking to get a better yield on your investments, you can let the professionals handle the buying, selling, and selecting of the specific individual dividend stocks with an Exchange Traded Fund (ETF).

An ETF is like a mutual fund except it is traded like a stock. There is an expense ratio, but compared to a mutual fund the expenses are usually very small.

This is more of a hands off approach. You simply decide what percentage of your portfolio you want to dedicate to dividend focused investments, pick a dividend ETF, and automate the purchase of shares. You could also look to mix and match specific ETFs that have different dividend strategies to increase your exposure to yield-bearing investments.

The pros to picking an ETF or a basket of dividend ETFs:

  • You don’t have to pick individual stocks.
  • You don’t have to watch individual stocks for good or bad news.
  • It is more of a “set it and forget it” investment.

The cons to picking an ETF or a basket of dividend ETFs:

  • You may get lower yield due to the number of companies the ETF or ETFs focus on bringing down the overall yield average compared to picking a handful of high yielding stocks.
  • You pay a little bit more in expenses. Stocks don’t have an expense ratio, ETFs do, and both have trading costs.

When Does Dividend Investing Make Sense?

I’m not looking to generate income off of my portfolio right now. I would need a portfolio of $1.25 million to generate a pre-tax dividend income of just $50,000 per year assuming a 4% dividend yield.  I think dividend investing is smart once you are closer to retirement or have grown your portfolio to the point that you can start paying for all of your living expenses with dividends rather than working.

In the meantime, I would rather focus my portfolio on growing to be large enough to generate a significant dividend yield. That means a focus on a balance mix of stocks and bonds, and a long time horizon.

What about you? Would you rather pick a handful of individual stocks on your own or leave it to the professionals (and algorithms)? 

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