Even with the fiscal cliff approaching and tax rates on dividends having the potential to go up, dividend paying stocks can still be a good investment. When you buy an individual stock, most brokerages offer you two options: pay dividends in cash, or reinvest the dividends. This can be an interesting choice for first time investors – do you continue to invest more in a company, or do you take the cash and run?
In a lot of circumstances, reinvesting the dividends can super-charge your returns, and that should be your first choice when opting to make the dividend reinvestment decision. Here is some of the math to prove it.
The Case for Reinvesting Dividends
The biggest case for reinvesting dividends is the power of compounding returns over time. It is the same case as putting money in a money market fund. If you invest in high-quality dividend paying stocks, like the dividend aristocrats, you not only get the perks of your income growing over time, but you also get to enjoy the potential price appreciation of the underlying stock.
Here is a good example. Say you invest $10,000 in Coca-Cola (KO), which pays a $1.02 per share (adjusted for split) dividend each year, and has consistently paid a quarterly dividend to shareholders since 1920.
Your $10,000 investment would buy you approximately 270 shares of Coca-Cola, which would earn you $275.40 per year in dividend income.
Now, if you reinvested that income at the same per-share price, you would now have 278 shares of Coca-Cola, which would earn you $283.56 the following year.
Over time, this compounding will continue to build, helping deliver better stock performance over time.
Here's some more math:
If you'd invested in 400 shares of Coca-Cola in 1984 (the same year Warren Buffett invested in it), you would have seen a 12.8% return on your investment on just price and stock splits, not including any dividend reinvestment.
Now, if you would have just taken the dividends in cash over this period, Coca-Cola would have paid out a little over $181,000 in dividends. That's a nice amount of cash, but just wait…
If you would have reinvested those same dividends over time, not only would you have earned an additional $84,000 in dividends (since the reinvested shares would also have paid dividends , but the reinvested shares would have also appreciated another $230,000, boosting your return from 12.8% to almost 17%.
Granted, Coca-Cola is a great performer over time regardless of dividends paid, but this same math holds true for many companies. The fact is that dividend reinvestment will boost your returns over time, sometimes dramatically.
Times When You Shouldn't Reinvest Dividends
There are some times when you shouldn't reinvest the dividends you receive in a company stock. These are mostly unique situations, or cases for advanced investing strategies, but you should be aware of them nonetheless.
- Income Strategies: If you're relying on dividends as part of an income strategy for your retirement, that you should opt to take the cash.
- Value Investing Strategies: If you're a value investor, you understand that price is important. If the price of a stock is higher than your intrinsic value, you may not believe that reinvesting dividends at that price is an optimal strategy. It may be a better bet to take the cash and find other value opportunities.
- Warren Buffett Doesn't: Yes, you heard that right – Warren Buffett's investing strategy is all about dividends, but he doesn't reinvest them. Instead, he loves cash, and keeps the cash to follow his value investing strategy.
- You Don't Believe in the Company: Sometimes, you don't think that the dividends or the company's business model is sustainable. There are sometimes when dividends don't matter, and a bad company may be one of these times. If you don't think the dividend is sustainable, take the cash and run.
As you can see, there are cases when you shouldn't reinvest dividends as well.
What are your thoughts on dividend reinvestment?
Great article. My mother reinvested dividends and did very, very well. She even left us GM stock that I did the same thing with until 2008. Then the company filed for bankruptcy and you know the rest of the story.
That could be one of those cases when you no longer believe in the company. It can be hard to call it quits on a company that you’ve had a life long attachment to though.
Good post highlighting the benefits on reinvesting. I would agree, that in general, it’s better to reinvest the dividends. I like how it can get you additional shares, especially if you’re a long term investor.
If you don’t have a better use for the cash and still like the company, than why not reinvest?
What if you don’t have better use today, but an opportunity could arise tomorrow? This is Warren Buffett’s thought – he sits on hoards of cash until he is ready to make a move. You never know when that could be though…
I’m a firm believer in reinvesting dividends, however I’d never thought about reasons NOT to do it (other than the 1st one you mentioned). I’ve never really sat down and done the month on a particular example as I understood the concept, but it’s nice to have it spelled out in black/white.
Interesting, I’d never really thought about the value investing strategy of using the dividends for other investments.
I’m a big fan of reinvesting dividends as long as the company is going to continually increase the amount year-over-year. That being said, that would be another good reason to not reinvest, and to possibly sell out as well–when the philosophy behind your choice changes. Like for me, if a company cuts or stalls the dividend growth, then I will cut off the reinvestment and use the money for other things, and if the reasoning behind the change is severe enough I’ll simply sell off my position.
I’m with you there. I had a company that traded at about $7-9 per share, but paid out a special initial dividend of $2, then a $1 dividend each year. I held the stock for about 10 years, so I was totally repaid for my shares. As the company’s growth stalled, I opted to take the cash, and eventually sold my total position.
I just came across your blog and love how easy it is to follow and understand. Generally when I read about finances my eyes glaze over if there is too much jargon involved.
I don’t reinvest dividend because I love cash too. The cash goes in to the general pool and I’ll buy more dividend stocks when I’m ready. I like this more because it will help with diversification. It’s generally not a good idea to be too concentrated.
Would you do the same thing if you invested in a dividend paying fund lor ETF like DVY?
I automatically reinvest dividends and capital gains even in my brokerage accounts.
I’m also a big fan of dividend reinvesting. You outline wonderful reasons to do it. OG doesn’t reinvest, but that’s because he (like Buffett) prefers to pick the next position with the cash. Most people that don’t reinvest have no disciplined approach to invest them otherwise, so I think they’re better off reinvesting them in the same position.
I try and reinvest all dividends. If I have cash left over, this is where I redeploy it.
Doing so has put me closer to $6,300 in dividend income for this year.
http://www.myownadvisor.ca/2012/12/november-2012-dividend-income-update/
I am a huge fan of reinvesting dividends. The best way to build the base of your retirement snowball is to use the power of compounding which happens with reinvesting your dividends. There are great sites like computershare and others that you can start your portfolio with a small amount in one stock.
As a newbie, I really appreciate this breakdown. So is that what they call “DRIP”ing? I am excited to get into investing, and want to allocate part of my portfolio to dividend paying stocks.
Yes, a DRIP is a Dividend Reinvestment Program, but is usually sponsored by a company. You can do your own DRIP by just reinvesting the dividends yourself.
Reinvesting dividends is a powerful way to boost your returns and build wealth. As I’m still a long way from retirement I reinvest dividends automatically to keep my positions growing. As I near retirement age I’ll switch it up and start cashing them out for income.
I won’t even look at investing in a stock if it does not offer a dividend. Companies that aren’t issuing a dividend do not have the shareholders best interest at heart, period. From 2001 to present the stock market is actually lower and the ONLY way you would have made money is by investing in stocks that issued dividends.