Dividend reinvestment allows investors to purchase additional shares with any cash received at low cost, amplifying the effects of compounding.
Whenever income investors receive cash dividends, they can choose to automatically reinvest them. This is a popular and influential method of accelerating the wealth accumulation effect. After all, with each additional share in a portfolio, the next time a company announces a payout to shareholders, 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 the cash dividends. Generally speaking, there are usually three options:
- Deposit money directly into a linked bank account.
- Keep the cash inside the brokerage account.
- Automatically reinvests dividends in the company that paid them.
The rollover option is also available to investors who do not hold their shares directly through a brokerage account. Instead, some companies offer a Dividend Reinvestment Plan (DRIP), which allows for automatic reinvestment of dividends without commissions or trading fees.
But why would an investor want to reinvest received cash dividends instead? As stated above, it is to speed up the effects of compounding.
The Compound Effects of Reinvesting Dividends
For example, XYZ Incorporated is currently trading on the stock market at a share price of 800 pence. Following the latest earnings report, management has announced its annual shareholder dividend of £0.50 per share. Therefore, an investor with 1,000 shares will receive £500, which he chooses to withdraw rather than reinvest.
The following year, XYZ Incorporated announces that 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 if they had reinvested the first payment of £500?
In this scenario, in the first year, the investor would have received £500, which is used to buy an additional 62 shares, as the share price has not changed. In the second year, they now own 1,062 shares. And therefore the second dividend payment equals £531. This brings the total cash dividend received over the two years to £1,031, an increase of 3.1% despite the fact that the dividends paid by XYZ Incorporated remain the same.
As seen in the illustration above, an investor could easily accumulate more shares in a company simply by reinvesting the dividends. It is like the capitalization of interest by an investor. Investors easily add more shares of a company they own without committing additional funds.
What are the advantages of reinvesting dividends?
Dividend reinvestment can be a lucrative strategy due to several factors.
- Low cost – Buying shares through an automatic dividend reinvestment plan or DRIP 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, you will adjust the average cost basis of a position within an investment portfolio. If the stock price were to fall, this would lower the average cost. If the share price goes up, the average cost goes up. This style of investing can be particularly advantageous during periods of high volatility.
- Long-term superior returns – As long as the underlying business survives and prospers over the long term, an investor who chooses to reinvest dividends will earn higher returns than those who do not. This is due to the composition effect.
What are the disadvantages of reinvesting dividends?
As advantageous as automatic rollover can be, there are some drawbacks that investors should consider.
- Dividend Non-disposable Income – Dividend income investors invest primarily in dividend stocks for the passive income it provides. However, when cash dividends are reinvested, the money is tied up in shares instead of being deposited in a bank account. While investors can always sell their shares to access capital, this can lead to losses due to share price volatility and trading fees.
- You can buy overpriced stocks – Dividend reinvestment occurs on the day companies pay dividends. However, if a stock is overvalued when dividends are paid, investors may overpay for a stock, raising the average cost basis and potentially destroying wealth in the process.
- Adversely affects diversification – Because dividends are reinvested in the companies that paid them, this capital cannot be used to further diversify an investment portfolio into new positions.
- Create portfolio concentration – Reinvesting capital in an income stock will slowly increase the size of a position within an investment portfolio. This can upset the balance and cause a portfolio’s risk profile to exceed an investor’s risk tolerance.
What is a Dividend Reinvestment Plan (DRIP)?
A dividend reinvestment plan, or DRIP, is a program initiated by some companies, but not all. It allows investors to reinvest their cash dividends to buy additional company shares automatically. However, there are some key differences compared to regular automatic rollover.
- DRIPs do not require a broker to waive any potential brokerage fees.
- Allows for the purchase of fractional shares.
- Some companies allow the repurchase of shares at reduced prices compared to the market.
The bottom line
Albert Einstein once said, “Compound interest is the eighth wonder of the world. The one who understands it earns it, and the one who doesn’t pay it.”.
This could be said of reinvested dividends. It could have such a powerful force in an investor’s portfolio. Apart from capital appreciation, an investor could use it to purchase additional shares of a company over time without committing additional funds.
So is it a good idea to reinvest dividends? It all depends on the goals of the investor. Someone with a long-term horizon is more likely to be able to afford to live without taking the cash from dividends. But another retired person may need the money to help cover living expenses.
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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment depends 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 should consider his or her individual financial circumstances and contact an independent financial adviser if necessary.
Edited and verified by
Master of Science Zaven Boyrazian
Zaven has worked in various industries throughout his career, from aircraft factories to game development studios. He has been actively investing in the stock market for the better part of a decade, managing over $1 million across multiple portfolios.
Specializing in corporate valuation, Zaven employs a modern version of the principles established by Benjamin Graham to find new opportunities at fair prices.
