Should Investors Reinvest Dividends?

Whenever income investors receive cash dividends, they can choose to automatically reinvest them. This is a popular and influential method of accelerating the wealth-compounding effect. After all, with each additional share in a portfolio, the next time a company announces a shareholder payout, the investor will earn more money.

But there are some situations where reinvesting dividends may not be the smartest move.

What is dividend reinvestment?

Many brokerage accounts allow investors to decide what should be done with cash dividends. Generally speaking, there are usually three options:

1. Deposit the money directly to a linked bank account.
2. Hold the cash inside the brokerage account.
3. Automatically reinvest dividends back into the company that paid them.

Choosing to reinvest is also available to investors that don’t hold their shares directly through a brokerage account. Instead, some companies offer a Dividend Reinvestment Plan (DRIP), which allows for automatic dividend reinvestment without commission or trading fees.

But why would an investor want to reinvest any cash dividends received instead? As previously stated, it’s to accelerate the effects of compounding.

The compounding effects of reinvesting dividends

For example, XYZ Incorporated is currently trading on the stock market at a share price of 800p. Following the latest earnings report, management has announced its annual shareholder dividend at £0.50 per share. An investor with 1,000 shares will therefore receive £500, which they decide to withdraw rather than reinvest.

The following year, XYZ Incorporated announces it will once again pay £0.50 per share as subsequent dividends. And therefore, the investor will receive another £500.

Over the two years, the investor has received a total of £1,000 in dividends. But what would happen if they had reinvested the first payment of £500?

In this scenario, in year one, the investor would have received £500, which is used to buy an additional 62 shares since the share price hasn’t changed. In year two, they now own 1,062 shares. And therefore, the second dividend payment is equal to £531. This brings the total cash dividend received over the two years to £1,031 – a 3.1% increase despite the dividends paid by XYZ Incorporated staying the same.

As seen from the illustration above, an investor could easily accumulate more shares of a company by simply reinvesting dividends. It is like the compounding of interest by an investor. Investors easily add more shares of a company they own without committing additional funds to it.

What are the advantages of reinvesting dividends?

Dividend reinvestment can be a lucrative strategy for several factors.

• Low Cost – Buying shares through an automatic dividend reinvestment plan or DRIPs is significantly cheaper than regular trading. Most brokers charge significantly reduced fees on these types of transactions.
• Automated Dollar Cost Averaging – By consistently buying a small number of shares over time, the average cost basis of a position within an investment portfolio will be adjusted. If the share price were to fall, this would bring the average cost down. If the share price rises, the average cost increases. This style of investing can be particularly advantageous during periods of high volatility.
• Superior Long-Term Returns – Providing that the underlying business survives and thrives over the long term, an investor who decides to reinvest dividends will reap higher returns than those that don’t. This is because of the compounding effect.

What are the disadvantages of reinvesting dividends?

As advantageous as automatic reinvesting can be, there are some drawbacks for investors to consider.

• Dividend Income Not Spendable – Dividend income investors mostly invest in dividend stocks for the passive incomes it provides. However, when cash dividends are reinvested, the money is tied up into shares rather than deposited into a bank account. While investors can always sell their shares to access capital, this can incur losses due to share price volatility and trading fees.
• Can Buy Overvalued Shares – Dividend reinvestment occurs on the day dividends are paid by companies. However, if a stock is overvalued when dividends are being paid, investors may overpay for a stock bringing the average cost basis up and potentially destroying wealth in the process.
• Adversely Affects Diversification – Because dividends are reinvested back into the companies that paid them, this capital can’t be used to further diversify an investment portfolio into new positions.
• Creates Portfolio Concentration – Reinvesting capital back into an income stock will slowly increase the size of a position within an investment portfolio. This may disrupt the balance and result in a portfolio’s risk profile exceeding the investor’s risk tolerance.

What is a dividend reinvestment plan (DRIPs)?

A dividend reinvestment plan, or DRIP, is a programme initiated by some, but not all, companies. It allows investors to reinvest their cash dividends to buy additional stocks of the company automatically. However, there are a few key differences compared to regular automatic reinvestment.

• DRIPs don’t require a broker to eliminate any potential brokerage fee.
• Allows for the purchase of fractional shares.
• Some companies allow shares to be repurchased at discounted prices compared to the market.

The bottom line 

Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it earns it, and he who doesn’t pays it”.

This could be said of reinvested dividends. It could have such a powerful force on an investor’s portfolio. Aside from the capital appreciation, an investor could use it to acquire additional shares of a company over time without committing additional funds to it.

So is reinvesting dividends a good idea? It all depends on the investor’s goals. Someone with a long time horizon is more likely to be able to afford to live without taking the cash from dividends. But another individual in retirement may need the money to help cover living expenses.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.

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