Should You Reinvest Dividends?

If you own stocks, whether it's through mutual funds, index funds, or individual equities, you're likely to receive regular dividend payments from at least some of those investments. You'll have a choice to make about what to do with these payments, since it's up to you whether to take the dividend as cash or to reinvest it in the stock or fund that just paid it out to you.

It might seem tempting to take the cash option so that you'll have flexibility to do what you want with it, including investing more in stocks. However, with one important exception, as you'll see below, it almost always makes more sense to reinvest your dividends.

What is a dividend?

Let's start with a few basics. When you buy a stock, you're purchasing an ownership stake in that business. You can think of this as a claim on the company's future earnings. A dividend, then, is simply the most direct way the company can regularly distribute those profits -- your profits -- directly to you, its shareholder.

Dividends come in a few different flavors. Most are paid out each quarter, or four times per year. Some companies pay less frequently, on an annual or semi-annual basis, and a few stocks send dividend checks out each month. There may also be sporadic dividend payments that happen as a result of a financial windfall or a stock split, too.

Companies aren't obligated to pay the dividends they forecast, and in fact, they are free to cut or cancel the payments at any time. In that way, a company's dividend amounts to more of an intention than a rock-solid promise.

In practice, though, most dividends -- at least ones from high-quality companies -- are extremely dependable. There is a huge penalty associated with a surprise dividend cut, for example, as investors typically punish a stock by selling following such a move. Conversely, the market rewards companies who pay out significant dividends and establish long track records of increasing their payouts.

Many S&P 500 stocks enjoy membership in an exclusive club known as Dividend Aristocrats, companies who have boosted their payouts for at least 25 consecutive years. Some stocks, including Procter & Gamble and Coca-Cola, boast over 50 years of consecutive dividend raises. Once a company establishes a dividend and builds up a track record of growth that stretches beyond a decade or more, it's relatively safe to assume that the dividend will continue being paid out for the foreseeable future.

Why dividend investing works

Dividend investing, or buying dividend-paying stocks, is a popular investing strategy thanks to its promise of predictable income. There's evidence that these companies tend to outperform their non-dividend paying peers, after all. Dividend stocks also provide the security of steady income that helps cushion investors' returns during industry downturns or market disruptions.

Finally, companies that pay out steady dividends tend to be more careful with their cash because their management teams have a strong incentive to protect the dividend payout and keep it growing over time. They are less likely to engage in risky debt strategies or make expensive acquisitions, a conservative posture that usually serves investors well.

These attractive characteristics have elevated dividend investing, also known as income investing, into a core investing approach. In fact, many investors use it to build a significant portion of their retirement portfolios. The strategy makes even more sense as an investor approaches retirement age and his or her need for steady income rises.

What does it mean to reinvest dividends?

With each dividend stock you own, your broker will give you the ability to reinvest dividends paid out by the company. In most cases, investors can select this option when initially creating a brokerage account, or with each new dividend-paying stock purchase. Choosing to reinvest dividends ensures that the cash the company distributes as a dividend will be used to automatically purchase more shares of its stock each time the dividend is paid.

For example, let's say you own ten shares of a dividend stock that is trading at $50 per share before it pays out a $5 per-share dividend. If you've decided to reinvest dividends, that $50 total dividend payment ($5 per share times 10 shares) would automatically purchase, or "reinvest," another share so that you'd own 11 shares after the distribution. Choosing the cash option, on the other hand, would have left you with the same 10 shares you started with, plus an extra $50 of cash in your portfolio.

In each case in this example you have $550 of value in your portfolio. With dividend reinvestment, though, all of that value is tied up in the stock rather than being split between the stock and cash.

Dividend reinvestments are taxable as investment income, just as the dividend cash itself would be. This is true even though the payment isn't available to you when it is directed back into the stock. The tax liabilities are modest, though, and in many cases, investors can avoid them altogether. In retirement accounts like IRAs, for example, the taxes aren't assessed. Dividend payments benefit from other tax-friendly characteristics, too, including reduced rates.

What is DRIP investing?

Besides the reinvestment option available through your broker, many companies offer the ability for prospective shareholders to purchase stock directly from the company itself. These investment vehicles, called dividend reinvestment plans, or DRIPs, frequently involve no transactions costs, although it is usually simpler for most investors to purchase dividend stocks in their brokerage or retirement accounts and set the account to automatically reinvest dividends.

If you want to look into company-run dividend plans, you'll have many good options. For example, Johnson and Johnson, one of the longest running dividend payers, offers a dividend reinvestment plan that allows for commission-free stock purchases and dividend reinvestments of up to $50,000 per year.

Many of the 30 companies that make up the Dow Jones Industrial Average offer DRIPs, too, although transaction and account fees vary. Thus, you're likely better off doing your dividend reinvesting through a reputable broker. Fidelity, for example, is one of several brokerages that does not charge transaction fees for dividend reinvestments. That alone is a great reason to favor dividend reinvesting, since fees can often be one of the biggest drags on an investor's long-term returns.

The single best reason to reinvest dividends

There are many compelling reasons to choose dividend reinvesting over taking cash, and we'll cover the most important ones here. But there's one factor that outweighs the rest by a wide enough margin that it deserves its own treatment. Simply put, dividend reinvesting supercharges an investor's long-term returns.

To see why, let's revisit the above example of the 10 shares you own of a $50 stock. After reinvesting the first $5 dividend, you now own 11 shares of a stock that pays $5 per share in dividends, which translates into $55 of regular dividend payments (up from $50 prior to your dividend reinvestment).

Reinvesting through the next payout, assuming no change in the stock's price, would deliver 1.1 shares into your portfolio so that you now own 12.1 shares that together pay $60.50 ($5 per share times 12.1 shares) in dividends. In other words, you received more dividends as a consequence of your earlier reinvestments, which in turn translate into greater purchasing power for the next reinvestment.

That multiplying effect is called compounding, and it forms the basis for the life-changing returns that can accrue for investors who hold on for the long term.

Just take a look at a few of these real-life examples, starting with consumer staples giant Procter & Gamble. P&G has been a bit of a disappointment for investors lately, having trailed the market by a wide margin over the past decade. The company made an aggressive gamble at restructuring its portfolio in 2016, but it went on to trail management's growth targets in each of the following two fiscal years. P&G is on track to accelerate growth a bit, and that success has led to a bump in the stock price. However, the shares are up only about 50% since late 2008, compared to a 180% increase in the S&P 500.

There's more to the story, though. P&G has paid, and increased, its dividend in each of the last 63 consecutive years. Include the reinvesting of dividends, and P&G's returns rise to over 100% in the past decade. Those trends are amplified over longer time periods, too. Holding just P&G stock since 1970 would have given you about 30 times your initial investment by late 2018, compared to about 22 times for the broader market. With reinvestments all along the way, though, that multiple rises to nearly 70 times for P&G shares.

Here are a few other examples:

• Healthcare giant Johnson & Johnson has returned 114% over the past decade, which puts it behind the market's 180% return. Add dividend reinvestments into the mix, and its performance becomes much better -- and beats the market -- at 197%.
• Starbucks doesn't pay an especially high dividend, and the coffee titan has only been paying regular dividends for less than a decade. Still, holding the stock since its 1992 initial public offering -- while allowing dividends to reinvest -- would have multiplied your money 20 times over, compared to 17.5 times without those tiny but powerful dividend reinvestments.
• Apple shareholders have seen their stock rise a market-thumping 1,100% in the past decade as the tech giant reaped huge benefits from its premium iPhone franchise. The Mac maker is also a recent joiner to the dividend party, but reinvestments have helped patient shareholders turn that return into 1,340%.

Sure, there is some cherry picking involved in these examples since they each describe a fairly successful business that has remained relevant to its customers over at least the last decade. Still, the math is the important takeaway, as it demonstrates how dividend reinvestments, even for relatively small payouts, supercharge investor returns. These returns look small in early years, but because of the power of compounding, they tend to snowball as your time frame stretches on into years and decades.

Four more reasons to reinvest your dividends

Besides the power of compounding returns, there are several other important reasons dividend reinvesting is a great deal for investors.

1. It's cheap. As mentioned above, dividend reinvestments usually don't trigger any transaction fees, which today can cost around $5 to $10 per trade. That means if you own a typical dividend-payer that sends out quarterly checks, you're getting as much as $40 per year in free stock purchase transactions. As always, make sure to double check with your broker to make sure it doesn't charge fees for these transactions.
2. It's automatic. As savers, we can often have good intentions that we don't always follow with the best actions. We aim to invest consistently, for example, in what's called "dollar-cost averaging," or buying a set amount of stock regularly whether the market is up, down, or flat. In practice, many investors try to time the market instead -- and end up ruining their long-run returns in the process. That's why, in general, financial vehicles like those automatic 401(k) deductions from the paycheck, which rely on automation, tend to work best. Dividend reinvestments fit in that category because they force steady, regular purchases of stocks.
3. It's flexible. Apple shares today are trading at about $180 each, and most brokers won't allow you to buy anything less than a single share. Dividend reinvestments are free from that restriction, though, as they automatically translate into fractional shares when applied to your investment. Thus, an investor can use dividend reinvestments to slowly build up positions in a high-priced dividend stock that they might otherwise not be able to afford. After your initial purchase of a stock such as Apple, subsequent purchases in the form of dividend reinvestments will accrue partial shares that increase your holding position over time.
4. It's disciplined. A favorite saying on Wall Street, coined by famous investor Warren Buffett, is that one should try to be "fearful when others are greedy and greedy when others are fearful." That means, generally, you should buy more stocks when prices fall, and buy fewer stocks when prices rise (even though most investors hurt their returns by doing the opposite, i.e., selling stocks during downturns and buying them after long rallies).

Dividend reinvestments support the Buffett approach. If your dividend stock drops as part of a market decline, for example, the reinvestments during this period will automatically purchase more shares of the underlying stock because the price is lower. The opposite is true during sharp market rallies, since you'll purchase fewer shares at the elevated prices.

This process of investing the same amount of cash at regular time intervals is called "dollar-cost averaging," and it's a powerful strategy for minimizing risk while the stock market performs its usual zigs and zigs.

When dividend reinvesting doesn't make sense

Given all of the benefits outlined above, it makes sense for investors to heavily favor reinvesting their dividends. Before we get to the single best reason to pass on dividend reinvestments, let's briefly cover two popular, but flawed, reasons to do so.

1. "The market is about to drop." -- It may be tempting to change your dividend reinvesting strategy based on your assessment that the stock market has risen too far, too fast, or that a particular stock may have outrun its valuation by a wide margin. This amounts to an attempt at market timing, which is difficult, if not impossible to do consistently. Investors are better off allowing the benefits of automatic dividend reinvestments to accrue rather than constantly trying to outguess the market and the pros on Wall Street.
2. "The business is going downhill." -- Dividend reinvesting is a bullish strategy, which means that, like investing in general, it generates healthy returns mainly when applied to companies that succeed in growing, or at least defending, their market share, over long periods of time. If you've decided that your initial investing thesis, or the reason you bought a dividend stock, is broken, then it makes more sense to simply sell the shares and move on rather than hold on to a stock simply for the income. It's a quirk of human psychology that we tend to be irrational about locking in losses, choosing instead to sell our winning stocks while holding on to the underperformers in hopes that they'll rebound. Famed investor Peter Lynch called that strategy tantamount to "cutting the flowers and watering the weeds" in your garden. Investors should aim for the opposite approach.

When to halt reinvestments

The one important exception would be if you are at or near retirement, or you have another legitimate need for the cash. You shouldn't be putting money into the stock market that you might need to access in at least the next five years, after all. Money you believe you will need in the short term is safer to hold in cash, or less volatile investment instruments like treasury bonds.

The time when you decide to begin living off of the portfolio you constructed over your investing years marks an ideal moment to shift from having dividends reinvested to having them delivered into your account as cash.

Assuming you've been an aggressive accumulator of stocks in the decades prior to that moment, you've taken at least some advantage of the compounding returns that dividends can provide, and you've avoided common pitfalls like overactive trading, then it's likely you'll have built up a significant revenue stream that can last you through retirement. The methodical reinvestment of dividends is a key tool that will help get you to that ambitious -- but achievable -- goal.

10 stocks we like better than Johnson & JohnsonWhen investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has quadrupled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Johnson & Johnson wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of August 6, 2018

Demitrios Kalogeropoulos owns shares of Apple and Starbucks. The Motley Fool owns shares of and recommends Apple and Starbucks. The Motley Fool owns shares of Johnson & Johnson and has the following options: long January 2020 $150 calls on Apple, short January 2020 $155 calls on Apple, and short October 2018 $135 calls on Johnson & Johnson. The Motley Fool has a disclosure policy.