Dividend Stocks vs Index Funds: How to decide

Investing in the stock market can feel overwhelming and complicated. One decision you’ll need to make is to choose between Dividend Stocks vs Index Funds, a mixture of both, as well as other investments for your portfolio.

Investing in individual stocks can feel like a lot of work and risky. You need to decide which are the best stocks to buy. And as a buy-and-hold investor, it feels like you never have enough information to choose the right investments.

We’ve all been there. After a few missteps with buying my first dividend stocks, I switched back to index funds because clearly that had to be the better approach. But was it?

Let’s take a closer look at investing in dividend stocks vs index funds, especially if you’re a long term buy-and-hold dividend investor.

Deciding between Dividend Stocks vs Index Funds

Let’s take a look at a Dividend Stocks

A dividend is a payment from a company distributing a portion of its earnings or (cash) reserves to its shareholders, usually quarterly. You receive income simply by holding the stock.

Check with your brokerage company because you can usually set the dividend to automatically reinvest the same company. By reinvesting each quarter you’ll receive a slightly larger dividend in the future payments because you’ll have slightly more shares that qualify.

And if the company increases the payout per share, usually announced annually, you’ll also receive a slightly larger payout. Over time, these slight increases snowball into larger quarterly and annual dividend payments. You may hear this referred to as the dividend snowball.

When choosing for companies to invest in, look for companies with a history of paying dividends, such as the dividend kings and dividend aristocrats, that were able to navigate through tough market conditions.

While there’s 100% of future returns on based past performance, it’s a helpful place to start as you build your investing experience.

It’s possible a company could cut or stop paying dividends for a variety of reasons: difficult company conditions, or mergers and acquisitions.

Related: Using Dividend Snowball Investing to grow your investment portfolio and income

And now a quick look at Index Funds

Index Funds are portfolios of stock holdings with a preset set of rules of what to buy, when sell, and when to hold. These portfolios don’t require as much from tracking from you as they are professionally managed. 

Index Funds invest in many different companies so this helps insulate the overall value of the portfolio if one of the companies runs into trouble. There a definitely pros and cons to investing in individual dividend stocks vs index funds.

The portfolio is professionally managed by people who monitor the market and the fund is likely ruled by guiding principles around what to buy, when to buy, and when to sell holdings.

The index fund may distribute capital gains and dividends. These earnings can be reinvested to grow your investment holding. And just like dividend stocks, your portfolio can snowball over time.

From my experience, this is where I had some trouble with my index fund holdings, especially in a volatile market.

With all the movement of share prices, I’m assuming the fund had an active year of buying and selling shares. Despite a year where I know the holdings paid dividends, the distributions for the year dropped by a huge percentage.

Index funds are not a bad investment type and really can help your overall portfolio. Some funds are managed better than others. Maybe part of your portfolio can still include some funds because they can give you access to stocks that are hard for the individual investor to buy directly.

Ultimately, you’ll need to decide which works best for you, your portfolio, your goals, and your risk tolerance.

Why my portfolio is focused on Dividend Stocks vs Index Funds

Years ago I lost my confidence in buying individual dividend stocks and switched to index funds. But after a year of dismal returns from my index funds, I decided to change my strategy. Researching the holdings of index funds helped me realize I could build my own portfolio of stocks using the funds as guidance.

Directly buying individual stocks you can control the holdings in your portfolio rather than delegate decisions to a third party. You can also estimate your potential monthly dividend income by holding mostly individual dividend stocks.

I started on this strategy using an IRA portfolio because I didn’t have to worry about capital gains taxes. Using the learnings from the first portfolio, I’m moving forward with building a similar strategy in taxable accounts, being very intentional about what to buy and when to sell.

Related: How to build a monthly dividend portfolio for passive income

Over to you. Do you prefer dividend stocks vs index funds?

Deciding between dividend stocks vs index funds can initially be driven based on experience. And sometimes you need to go through those cycles to build confidence in order to build the investment portfolio that’s right for you.

Or maybe you chose to invest in something else. How are you deciding what to buy and when to sell?

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