There are a few basic concepts every good investor must understand. These concepts include dollar-cost-averaging, risk tolerance, expected return, and dividends. Grasping the idea of dividends is confusing for many. Some people look at it as income. Other people (like Warren Buffett) don’t care about dividends whatsoever. Others, like this guy, believe dividend income is an important part of financial freedom.
The final group of people are those who don’t give dividends the time of day. They passively reinvest them.
As you can tell, there are many ways to approach the subject. My goal with this article isn’t to spout my personal beliefs. It’s not to say reinvesting dividends is correct for your situation. I don’t know your exact situation. Thus, I’ll simply be giving the reasons everyone should consider reinvesting dividends. There are three good reasons I’ll outline below.
For simplicity’s sake (and to keep this article from being 5,000+ words) I will talk solely about reinvesting within a taxable account. The situation changes dramatically from one investment vehicle to the rest: taxes, rebalancing, deposit caps, withdrawal options… that article would go on for ages. Perhaps we can cover the other investment vehicles at a later date. For now, here are the reasons to reinvest dividends within a taxable account.
Reinvesting dividends is just plain easy. Simple. No math required. It’s as easy as checking a box. Many people enjoy taking a long-term, passive road to investing success. There’s nothing more passive than allowing dividends to buy more dividend-producing stocks.
reinvesting dividendsNo Purchase Fees
Since the money never leaves your investment account, there are typically no purchase fees involved (as with Vanguard, for instance). Think about it like this… when you take a dividend, you pay capital gains as you exit the investment account. You may do this on October 31st. But then on November 15th, you may put more money into the investment account. It may in fact be the same money you just withdrew as a dividend. How much sense does that make? It doesn’t make sense.
However, reinvesting dividends to avoid the purchase fee isn’t a massive win. It will hardly disrupt your early retirement plans.
Let’s say you get $300 per quarter in dividends. If you take it out and reinvest it later with a .50% purchase fee, that’s only $1.50 lost (not taking into account your capital gains tax rate – which could be zero).$1.50 buys you what, a king-sized candy bar at a gas station?
This is my favorite reason for reinvesting dividends. It’s the most important. When you take a dividend out of the stock market, you’re taking your money out of production. Yes, you may put it back later but it’s still gone for at least a few business days. The markets wait for no one. During that time you spent shuffling money, your fund has probably grown. Historically, the stock market always goes up.
Let’s assume the stock market will give you an 8% gain, and that you earn a 2% dividend yield. Let’s also assume the dividends come once per month; and you contribute $10,000 per year. That new money enters the stock market on a monthly basis. This is how your investments will grow:
After 10 years of not reinvesting dividends: $166,336.55
After 10 years of reinvesting: $166,454.87
After 20 years of not reinvesting dividends: $503,438.98
After 20 years of reinvesting: $504,229.21
After 40 years of not reinvesting dividends: $2,797,664.94
After 40 years of reinvesting: $2,807,810.40
Reinvesting means a difference of $10,145.46 over 40 years.
Decide What’s Right for You
Reinvesting within a taxable account makes sense of many reasons. It’s easy. You’ll likely pay fewer fees. And your money can work harder for you. However, it may not be right for your situation.
Perhaps you would rather take the dividend and put it towards your living expenses. Perhaps you like using dividends as your annual vacation fund. Or perhaps you flat out have to take the money ASAP. The fact is, if you’re getting dividends, you’re already doing really well. Keep on investing.