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Why You Should Be Reinvesting Dividends

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American Flag outside the Wall StreetI’ve been investing in a few dividend stocks lately because savings account rates have been pretty abysmal. The prospect of earning a percent or two on my money is great for an emergency fund but lousy for anything long term.

One of the important ideas behind dividend investing is that you should reinvest the dividends if you don’t need the income. Public companies offered dividend reinvestment plans, or DRIPs, that let you buy shares directly from them and have your dividends reinvested for free. Nowadays, many brokers offer this service for free and I take advantage of them.

However, just because everyone says it’s a good idea doesn’t make it a good idea. Why should I reinvest my dividends?

The main argument, as far as I can see, for reinvesting dividends is because you get to dollar cost average additional shares at no additional cast, assuming your broker offers free dividend reinvestment (and many do). It’s recommended that you reinvest dividends because it lets you buy more of a company you had confidence in at absolutely no cost.

You still pay taxes on the dividend income. So if you do reinvest, be sure to account for the tax you owe on the dividend because the entire dividend will be reinvested. For example, I own a few shares of Costco (COST) and get paid a small dividend of $0.18 a share every quarter. If I had 100 shares, I’d get $18 a quarter reinvested in the form of Costco shares. In turn, I’d owe 15% in taxes on the $18 so I need to set aside $2.70 in taxes.

If you read about the subject elsewhere, they’ll show you numbers about how reinvesting is better than not reinvesting but I think they’re unfair comparisons. If you reinvest dividends, you’re investing more of your money and so if it appreciates then you make more. If the stock falls, you lose more money. Over the long run it’s more likely that you will gain more but it’s not a 100% certainty, plenty of well-known and illustrious companies see their stock price fall to $0.

Dividend reinvestment is a great way to accumulate additional shares in a company you believe in and those shares will, in turn, pay out dividends. It isn’t, however, some sort of fancy magic. :)

(Photo: epicharmus)

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21 Responses to “Why You Should Be Reinvesting Dividends”

  1. Mark says:

    As someone who is still midway thru this process of gathering my retirement stockpile, I love stocks that have dividends. I go back to the example of mom getting 1 share of coca-cola when she was young, and between splits and dividends that 1 share became 800+. Now granted that took decades, but from a long term investment perspective, it worked out pretty well.

    • jsbrendog says:

      if only we could all be so lucky. then again I guess buying just 1 in an company is a low risk high reward if you can wait that long for it to pay off.

      it is mind boggling how that 1 turned into 800+?? holy crap

  2. I’m not a fan of DRIPs. I used them many years ago and think it is a mistake for small investors to tied up their money in individual stocks. I’d rather see them buy broad based market index funds or ETFs and reinvest those dividends… play the winner’s game instead of gambling.

    • The other problem with DRIPs is tracking cost basis. The company doesn’t do this for you if you purchase directly from them (which is usually advised by people who promote DRIPs so you can avoid commissions)

      So you either need to have an excellent system for tracking this yourself (most people don’t) OR you need to do this sort of investing in a brokerage account (which means you’ll pay commissions). Otherwise, you’ll end up having to claim a $0 tax basis when you sell or you’ll have to go through years and years of records painstakingly calculating your cost basis. Not fun…

      • Steve Bonds says:

        I’ll second this– with auto-reinvested dividends tracking the basis of all those individual transactions can rapidly become a serious pain.

        It may be worth the cost of losing a tiny amount of return to instead choose to not automatically reinvest dividends and manually reinvest them on a quarterly basis. This works especially well if you can arrange for free commissions, otherwise those costs will destroy your returns.

        • Mike says:

          For most investors that should be the case. However, most of my stocks are not available on these index funds and etfs. Perhaps when they create an etf for my high yielding stocks I will buy it. For now, I’m happy creating my own diversified fund of high yielding stocks.

  3. Two main reasons for reinvesting dividends:

    1) It’s commission free. Do not reinvest through your broker. Use DRIP, the free dividend reinvestment plan

    2) The true growth of a stock portfolio – if there is any growth – comes from compounding earnings. Those dividends count over an extended period of time.

    Mark

    • Darin says:

      Bank Of America lets you reinvest for free.

      The Advantage of many DRIPs is that you can buy *additional shares* for free instead of paying commissions.

  4. We’re currently looking at treasury-guaranteed mortgage-backed securities let by ginnie mae. Those pay 4.5% with an average 2 year maturity rate. The risk with Ginnie Mae mbs’ is in how long they keep your money. If rates jump, they can hold your money for as long as 15+ years, paying you 4.5% the whole time.

    That said, these aren’t traditional bonds. They are self-liquidating (like mortgages)… so the risk of getting ‘stuck’ diminishes pretty fast. They also project a ‘likely holding period’ based on current conditions… It’s an interesting alternative to dividend stocks.

  5. WR says:

    I reinvest all of my dividends for precisely the reason you cite. I am investing for the long haul.

    That said, I love REITs for this exact thing. Thing about REITs that are nice is that they are required to pay dividends of at least 90% of taxable income.

    Favorites are CGMRX and VGSIX
    http://www.google.com/finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=0&chdet=1268689602015&chddm=7820&cmpto=MUTF:CGMRX;MUTF:TRREX&cmptdms=0;0&q=MUTF:VGSIX&

    CGM is by far the top performer historically, T Rowe Price is very nice as well, Vanguard has only a 0.26 expense ration which is important over the long term. Expenses and turnover can eat up your earnings.

    With the nice yields REITS offer, you don’t really have to worry *too much* about the price changes if you plan to hang on to them long term. Right now they are still a pretty good deal.

    I bought VGSIX (3K min investment) when it was hovering around 10.00/share. After quite a bit of research this will be a permanent part of my portfolio. plan on adding CGMRX down the road.

    -WR

  6. zapeta says:

    I reinvest my dividends, the compounding really does count over a long period. Ideally the dividends will grow and provide me a stable income in retirement.

  7. Dividend reinvesting is definitely a great way to accelerate compounding. Like you pointed out, it does increase your “exposure” to the stocks that you’re actively reinvesting in. So in that light, it becomes more important to keep track of it when re-balancing your portfolio.

  8. I agree, with savings accounts so low now may be the time to invest in dividend paying stocks and reinvest the dividends. It might be worthwhile to also look at some preferred stock – they usually pay higher dividends and some are still trading at depressed levels because they were beaten down so badly.

  9. HT says:

    I prefer to just pool the dividend money and lump it into my next purchase. So lets say I am investing money Monthly, just for the sake of easy math let’s say I invest $500 per month January through October to max my IRA. Each month I’ll actually make a larger than $500 investment of stock by adding my dividend money in with my new cash investment. I was going to pay the commission anyway, and it helps my investments grow over time.
    -HT

  10. Money Infant says:

    It’s a pretty good bet that for most smaller investors you’ll do better with mutual funds (no load!) and ETF’s anyway. Once you have a larger capital base it makes sense to diversify through individual stocks, but if you have less than say $50,000 to invest I would say just stick with the mutual funds or ETF’s.

    And yes, definitely re-invest dividends, that is part of what will bring you the power of compounding.

  11. Good points! I have been looking into some good paying companies. AT&T recently announced a dividend increase for I think the 26th or something?

  12. jsbrendog says:

    I had some stock in a local electric company from when i was younger that reinvested dividends. When they were purchased a couple years ago and I got my payout and looked at the documentation it was a sound decision to reinvest them. granted, as you stated, it might not work out, but IMO it is the right choice.

  13. JB says:

    I purchase stock through an Employee Stock Purchase Program at work. The company pays a regular dividend, which I happen to take in the form a check. This is due to the fact that if/when the dividend is reinvested, it is done at the market price of the stock, not the employee price which is much lower. Might want to check on that if you purchase stock through an ESPP.

  14. eric says:

    Glad to see you jumping in after so many posts about it. Keep updating for the uninitiated like us! :)

  15. Bill says:

    No, reinvesting is for the very lazy, ever trusting beginners. When a company turns bad you lose, and don’t think it cannot or will not happen to your favorite. Accumulate dividends, then put in a good conservatine bond ETF, not a mutual fund. There, I said it.


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