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Reinvesting can be automatic, but your decision shouldn't be

Quick Summary

  • A dividend is a reward (usually cash) that a company or fund gives to its shareholders on a per-share basis.
  • You can pocket the cash, or reinvest your dividends to buy more shares of the company or fund.
  • Reinvesting can help you build wealth, but it’s not always the better choice.

For many investors, dividend reinvestment makes perfect sense. After all, it can be an easy way to build wealth. Still, there are times when it’s better to pocket those dividends. Here are arguments—for and against—automatically reinvesting your dividends.

How To Set Up a Dividend Reinvestment Plan

In general, there are two ways to set up automatic dividend reinvestment:

  1. If you invest through your brokerage account, you can choose to reinvest your dividends instead of receiving them as payouts.
  2. You can invest through a Dividend Reinvestment Plan, or DRIP, if the company you want to invest in offers one.

Company-run DRIPs are commission-free because a broker doesn’t need to facilitate the transaction. But if the DRIP is operated by a brokerage firm (they can buy shares from the secondary market to add to your account), you’ll probably pay a commission on each reinvestment.

Pros and Cons of Dividend Reinvestment

Pros

  • Easy button

  • Dollar-cost averaging

  • No transaction costs

  • Automatic investment growth

  • No tax consequences in retirement plans

Cons

  • Lose money in a falling market

  • Less opportunity to diversify

  • Can unbalance your portfolio

  • Can end up buying high

  • May need to rebalance more frequently

Why You Should Reinvest Your Dividends?

One of the best reasons to reinvest your dividends is that it’s an excellent way to grow your portfolio. This is especially helpful if you plan to hold your shares for the long-term, and don’t need the income now. There are other benefits, as well:

Effortless investing

Another major advantage of dividend reinvestment is that it makes investing really easy. Once you set it up, you don’t have to do anything to make the investment happen. This can be especially advantageous if you like a certain stock or mutual fund and are satisfied with its history of long-term returns.

Dollar-cost averaging

Automatic dividend reinvestment is dollar-cost averaging in motion. Because you invest periodically—typically four times per year when dividends are paid—you buy additional shares on an ongoing basis. This means you can avoid loading up on a stock or fund when the price is high, and instead, average the costs over time.

No transaction costs

Automatic dividend reinvestment benefits a company or mutual fund because it keeps money flowing back into the stock or fund. For this reason, companies and funds 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 happens with securities in a 401(k), 403(b), traditional or Roth IRA, or some 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 is 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. That means 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 buy at the higher price. Your exposure to an over-priced stock could increase 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 it will increase your exposure in a declining one.

Less rebalancing, lower transaction costs

Dividend reinvestment increases investments 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 happens without you needing to do anything once you’ve established the plan. 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.

 

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