If your stocks make regular dividend payments, you may be wondering whether you should reinvest those dividends.
It’s an important question. For long-term investors, reinvesting dividends helps you build up the value of your investments over time due to compounding. My colleague Tom Hutchinson has an excellent primer on the pros and cons of reinvesting dividends. I encourage you to read that, if only for his explanation of “dividends on dividends” and the value that brings for an investment with a long time horizon.
[text_ad]
Whether or not you should reinvest a dividend ultimately comes down to your needs, especially whether you need income or if you’re saving for the long haul.
Setting aside the value of “dividends on dividends,” we thought it would be useful to offer a straightforward explanation of when you should reinvest dividends and when you shouldn’t, as well as some practical concerns you may not have thought about.
You Should Reinvest Dividends if…
Saving is a struggle. First and foremost, set aside an emergency fund. If you struggle to save because of cash flow issues to begin with, you should first work on building a stable foundation. That means paying off credit cards and building up three to six months’ worth of emergency savings.
Once you’ve got a stable foundation, reinvesting dividends can help automate your investing by putting the extra money you receive from dividends into the stocks you already want to own. It may only be a few dollars or a few hundred dollars each quarter, but it adds up over time.
You’re investing for the long haul. A common saying you’ll hear from financial advisors is that “it’s time in the market, not timing the market.” Trading isn’t for everyone, but long-term investing has proven over decades to be the most reliable way to grow your net worth and beat inflation. If you’re a long-term investor, reinvesting dividends is not much different from a strategy known as “dollar-cost averaging” (buying a fixed dollar amount at regular intervals regardless of the underlying share price).
The logic is that because it’s so difficult to time the market, you don’t even try. Simply buy periodically and let the long-term performance of stocks drive your returns. If your 401(k) contributions automatically invest in a blend of funds, you’re already practicing dollar-cost averaging without even knowing it.
You want to build up more of the dividend-paying stock or fund. Ultimately, when you choose to reinvest dividends you are taking money that would otherwise go to cash in your account and using it to buy more shares.
If you’re deciding whether you should reinvest dividends, it all boils down to whether you want to own more of the dividend payer, for whatever reason. If you do, reinvestment is a good way to do that.
You Shouldn’t Reinvest Dividends if…
You need the cash. If you need the cash because you’re struggling, see the first point above. But if you need the cash because your dividend-paying stocks are a source of income, then there’s nothing wrong with skipping the dividend reinvestment. Put another way, once your retirement savings are actually paying for retirement, using dividends as income is just part of your portfolio doing what you hope (and plan) that it will.
You’re a trader. If you’re a trader and not a long-term investor, go ahead and skip the dividend reinvestment. I’ve lost count of how many times I helped clients who were traders close out dividends that reinvested after they sold shares. (Back when brokerage firms still had commissions, we’d waive those commissions as a policy for “courtesy sales” where we sold small positions and partial shares after something like a stop-loss or sell limit order triggered.)
If you’re a trader, you shouldn’t be worrying about whether you’re going to have to do some minor account cleaning just because you happened to sell a stock after its ex-dividend date but on or before its payment date.
You’re too invested in the dividend-paying stock (directly or indirectly). One important factor of long-term investing is diversification. It comes in a lot of different flavors, but for most investors, it means not having too much exposure to any one stock or sector (you don’t want one bad earnings report from a company swinging your entire portfolio).
If you already own a lot of one stock (directly) or via a combination of the individual stock and the ETFs you own that also own that stock (indirectly; especially relevant these days with the Magnificent Seven stocks), reinvesting dividends works against you by adding even more exposure.
For instance, if you own the S&P 500 ETF (SPY) and reinvest dividends (about a 1.25% distribution annually) it doesn’t reinvest into only the dividend payers, it reinvests into the whole basket. So, as of this writing, 6.3% of that distribution buys more Microsoft (MSFT), 7.1% buys more Apple (AAPL) and 6.8% buys more Nvidia (NVDA).
You can always split the difference and reinvest your SPY dividends while not reinvesting your MSFT dividends, for example. The right balance will be up to you.
These are just a few quick boxes you can check to help decide whether or not to reinvest dividends, ultimately it comes down to what works best for you.
[author_ad]
