Automatically reinvesting your dividends has a lot of benefits, but does that make it the best choice for your retirement assets? There are good reasons to reinvest, but at least as many reasons not to do it. This story looks at both sides.
Why You Should Reinvest Your Dividends
One of the major advantages of dividend reinvestment is how easy it is to do. Many large companies offer Automatic Dividend Reinvestment Plans, also known as a “DRIP.” These allow investors to use their dividends to purchase additional shares on the dividend payment date. There are other advantages.
This is the classic feature of dividend reinvestment—the investing just happens without you having to do anything to make it happen. This is especially advantageous if you like a certain stock or mutual fund and are satisfied with the history of long term returns.
Automatic dividend reinvestment is dollar-cost averaging in motion. Because you’re investing periodically—typically four times per year when dividends are paid—you’re buying additional shares on an ongoing basis. This means that you avoid loading up on a stock or fund when the price is high and instead average the cost of acquisition continually.
No transaction costs
Automatic dividend reinvestment is a plan that benefits a company or mutual fund because it keeps money flowing into the stock or fund. For this reason, companies and funds will typically administer the plan for free. That means you buy stocks and funds with no transaction costs.
Automatic investment growth
If the stock or mutual fund in which you’re reinvesting dividends has been rising in value, the additional purchases will increase your position and gain over time.
No tax consequences for reinvestment in retirement plans
Dividend reinvestment plans can be a tax-preparation nightmare for taxable transactions. You have to account for each purchase in order to avoid double taxation (tax on the dividend income itself, then understated cost basis on sale increasing capital gains). But if the reinvestment is happening with securities in a 401(k), 403(b), Traditional or Roth IRA, or other tax-sheltered plan, the tax consequences can be ignored.
Why You Might Not Want to Reinvest Your Dividends
Automatic reinvestment isn’t always a good idea. Here’s how you benefit if you don’t reinvest.
Avoid losing more money in a falling market
The advantages of dividend reinvestment that work so well when a stock or fund are rising in value will work in reverse if the security is falling. In this situation, the increased position that dividend reinvestment brings will also increase your exposure to losses.
Increased opportunity to diversify
By taking dividends in cash, instead of reinvesting them, you open up the opportunity to diversify into other assets rather than loading more money into the positions you already have.
Won’t unbalance your portfolio
The success of a dividend reinvestment program could also prove to be its undoing. Higher-yielding, faster-growing securities have a way of building up far quicker than other assets, meaning it will just be a question of time before you’ll be overweight in a few securities. While the market is strong and those securities are performing well, that arrangement will be a plus. But if those securities fall out of favor, the losses will be that much greater.
Avoids exposure to over-priced stock purchases
If a stock was a good bargain at $20 a share, it might not be at $50, but your dividend reinvestments will still be buying at the higher price. Your exposure to an over-priced stock is thus increasing with each dividend reinvestment.
Income diversification from cash dividends
In a well managed portfolio, some income will be in the form of dividends and some will be capital appreciation. But by reinvesting dividends you’re effectively converting dividend income to capital appreciation. If all of your securities have the reinvestment feature, your portfolio will depend entirely on capital appreciation. That will be a plus in a rising market, but will increase your exposure in a declining one.
Less rebalancing, lower transaction costs
As outlined above, dividend reinvestment increases investment in the most successful securities, and this can result in the need for more frequent rebalancing. Since rebalancing requires selling better-performing assets and buying lower-performing ones, it will mean more frequent trades and higher transaction costs. This is especially true if you hold individual stocks.
More investment choices
The beauty of automatic dividend reinvestment is the auto-pilot feature—something is happening without you needing to do anything to make it happen once the plan has been established. What this means is that investment choices also become automatic. For example, in a rising stock market, dividend reinvestment will mean that stocks will grow as a percentage of your portfolio at an even faster rate than if you took the dividends in cash and invested it in bonds or money markets instead of in stocks.
Automatic dividend reinvestment is an attractive option, but like other investment activities, it isn’t perfect. Consider the advantages and disadvantages—and personal preference, such as how much you time you want to spend trading compared to investing on auto-pilot—before deciding to participate in it.