Please ensure Javascript is enabled for purposes of website accessibility

The Pros and Cons of Reinvesting Dividends

Reinvesting dividends offers you the extra earning power of compounding, but if you’re on the fence about it, here are a few other factors to consider.

Sparklers and Champagne Glasses

If you’re a regular reader, you probably know that we’re big fans of dividends here at Cabot. Especially for long-term investors.

And reinvesting those dividends gives you the opportunity to compound your returns over time. Not only are you buying more shares of a company you already like, but those reinvested dividends are paying their own dividends. (My colleague Tom Hutchinson calls these “dividends on dividends.”)

That reinvestment each year can massively increase your yield on cost (current distribution divided by the original purchase price). Given enough time, and you can find yourself in the same boat as Warren Buffett, making as much from dividends every few years as you spent on the original investment. (With an original investment of $1.2 billion in Coca-Cola (KO) and about $740 million in annual dividends, Buffett’s yield on cost is more than 50% and he recoups his original investment every two years from dividends alone.)

With that kind of long-term potential, reinvesting dividends seems like a no-brainer. And it just might be, but it ultimately comes down to your needs as an investor.

So, we thought it would be worthwhile to offer a straightforward explanation of when you should reinvest dividends and when you shouldn’t, as well as some practical implications that you may not have otherwise considered.

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 the investing process by putting the extra money you receive from dividends into the stocks you already want to invest in. 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 increase your equity exposure to the dividend-paying stock or fund. Both of the points above are variations on this point. 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 generating income in retirement, then there’s nothing wrong with skipping the dividend reinvestment. Put another way, once you’ve reached the distribution phase of your investing journey, 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 overallocated to 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’re overweight a stock (directly) or via a combination of the individual stock and your ETF exposure to 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, 7% of that distribution buys more Microsoft (MSFT), 6% buys more Apple (AAPL) and 5% 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.

Since it’s so individually specific, there’s no rule of thumb on when you should reinvest dividends, but hopefully, these considerations can make the decision easier for you.

Brad Simmerman is the Editor of Cabot Wealth Daily, the award-winning free daily advisory.