Dividend Debate: Reinvest to Compound Returns vs. Other Uses

To DRIP or not to DRIP? Dividend reinvesting can be a powerful compounding tool, but you might consider taking the income for other purposes.

https://tickertapecdn.tdameritrade.com/assets/images/pages/md/Dividend debate: Should you always, or automatically, reinvest in shares?
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To reinvest or not to reinvest—that is the dividend question. As a young investor going through the financial tug-of-war between current wants and needs, and future retirement plans, should you use dividends to pay for some of your current expenses, or reinvest them in additional shares? The answer? Check your investing goals.

“Reinvesting dividends to buy more shares is a great way to compound total returns,” says Robert Siuty, senior financial consultant at TD Ameritrade. “The downside is if the dividend gets cut or the company falls on hard times, you may have been purchasing at higher prices than where it could be trading at a future date.”

Plus, people have expenses. There are bills to pay, and even workaholics need a vacation now and then. Dividend income, even if you’re young, can potentially be used to help defray some of these expenses.

Read on to see whether dividend reinvesting might be right for you.

The Dividend Reinvestment Short Course

Dividend reinvesting can be achieved one of two ways—through a program or on your own.

  • DRIPs. Some companies offer direct share purchases (where you buy your shares directly from the company rather than on an exchange) and, instead of receiving your dividends in cash, you receive additional shares. This type of program is called a “dividend reinvestment plan,” or DRIP. Some DRIPs allow additional shares to accumulate commission-free, and they’ll even issue partial shares. 
  • Reinvest on your own. Instead of receiving your dividends by check, for example, you could have them automatically deposited into your account, and when you have enough money to accumulate additional shares, you can buy them on the open market.

Not all companies offer DRIPs. And because they typically come from the company’s private stock, they often can’t be sold in the secondary market (on an exchange). Buying on your own can increase your universe of investment choices, but making multiple small-share purchases can mean higher transaction costs over time.

How Does Compounding Work?

Can’t decide? Take a look at what compounding does in the reinvestment world. Let’s consider a $10,000 investment in a stock with a 3% annual dividend and apply some simple math. The first year, that investment will have risen to $10,300. If the company pays the same 3% annual dividend the next year, it would grow to $10,609. Repeat in year three, and the investment would be $10,927. Repeat for 10, 20, 30 years … and you get the idea of how compounding can enhance potential returns.

This scenario, however, doesn’t take into account the value of the stock itself. If the stock price has appreciated at the same time, say 5% annually, the total return would be 8%. By year three of this example, that 8% return on the stock would have grown to $12,597 and change.

But remember, this is a simplistic look. Dividends and dividend rates fluctuate, as do stock prices. Past performance is not a barometer for future results. The stock market doesn’t climb in neat trajectory angles; it zigs and zags, sometimes dramatically. And companies cannot guarantee their dividend payouts; profits rise and fall, business cycles happen, and the economy can be bumpy. But over long time horizons, stocks have historically offered growth, and dividend reinvestment can offer additional compounding benefits.

Should You Always Reinvest?

It depends on your goals and financial needs. There is no right or wrong answer here because the correct response is what best fits your own personal situation.

“One course of action with dividend income an investor could consider is to reinvest in your portfolio to keep the money working as long as possible,” Siuty says. “That way you’re saving more, growing more, and accumulating more.”

What if you need that income to relieve daily expenses, or to fund a big-ticket item, a vacation, or education expenses? “Taking the income in those situations might make sense, too,” Siuty says. “You’re still maintaining a position in the stock, but you’re taking the income that’s produced by that holding and using it to supplement your lifestyle, while still keeping the same amount of shares within the company and hoping to get capital appreciation.”

That approach doesn’t come without the caveat to keep a close eye on the stock, its price, the dividend, and how the company is paying the dividend. And although you might save on transaction costs when dividends are automatically reinvested through a DRIP, you don’t get to sidestep taxes on the dividends. 

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