September 12, 2011

Automatically reinvesting your dividends has a lot of features that make it attractive, but does that mean you should do it—especially in connection with your retirement assets? There are good reasons to reinvest, but at least as many reasons not to do it. How you choose to handle your dividends may have more to do with personal preference than anything. One of the major advantages of dividend reinvestment is the ease with which it’s done. Many large companies offer Automatic Dividend ReInvestment Plans, also known as a “DRIP”. They allow investors to reinvest their dividends by purchasing additional shares on the dividend payment date. There are other advantages.

Why you should reinvest your dividends

Investing becomes automatic. This is the classic feature of dividend reinvestment—the investing just happens without you having to do anything to make it happen. This is especially advantageous if you like a certain stock or mutual fund and are satisfied with the history of long term returns.

Dollar cost averaging. Automatic dividend reinvestment is dollar cost averaging in motion. Because you’re investing periodically—typically four times per year when dividends are paid—you’re buying additional shares on an ongoing basis. This means that you avoid loading up on a stock or fund when the price is high and instead average the cost of acquisition continually.

No transaction costs. Automatic dividend reinvestment is a plan that benefits a company or mutual fund because it keeps money flowing into the stock or fund. For this reason, companies and funds will typically administer the plan for free. That means you buy stocks and funds with no transaction costs.

If you reinvest dividends it helps your investment grow. If the stock or mutual fund you’re reinvesting dividends in has been rising in value, the additional purchases will only increase your position and gain over time.

There are no tax consequences for dividend reinvestment in retirement plans. Dividend reinvestment plans can be a tax preparation nightmare for taxable transactions. You have to account for each purchase in order to avoid double taxation (tax on the dividend income itself, then understated cost basis on sale increasing capital gains). But if the reinvestment is happening with securities in a 401k, 403b, traditional or Roth IRA or other tax sheltered plan, the tax consequences can be ignored.

Why you might not want to reinvest your dividends

If the stock falls, you lose more money. All the advantages of dividend reinvestment that work so well when a stock or fund are rising in value will work in reverse if the security is falling. In this situation, the increased position that dividend reinvestment brings will also increase your exposure to losses.

Restricts the opportunity to diversify into other securities. By taking dividends in cash, instead of reinvesting them, you open up the opportunity to diversify into other assets rather than loading more money into the positions you already have.

A high dividend paying stock could cause the investment in that stock to eventually become overweight. The success of a dividend reinvestment program could also prove to be its undoing. Higher yielding, faster growing securities have a way of building up far quicker than other assets, meaning it will just be a question of time before you’ll be overweight in a few securities. While the market is strong and those securities are performing well, that arrangement will be a plus. But if those securities fall out of favor, the losses will be that much greater.

Dividend reinvestment can cause future investments at higher prices. If a stock was a good bargain at $20 a share, it might not be at $50, but your dividend reinvestments will still be buying at the higher price. Your exposure to an over priced stock is thus increasing with each dividend reinvestment.

Cash dividends represent an income diversification. In a well managed portfolio, some income will be in the form of dividends and some will be capital appreciation. But by reinvesting dividends you’re effectively converting dividend income to capital appreciation. If all of your securities have the reinvestment feature, your portfolio will depend entirely on capital appreciation. That will be a plus in a rising market, but will increase your exposure in a declining one.

Dividend reinvestment can complicate rebalancing. As outlined above, dividend reinvestment increases investment in the most successful securities, and this can result in the need for more frequent rebalancing. Since rebalancing requires selling better performing assets and buying lower performing ones, it will mean more frequent trades and higher transaction costs. This is especially true if you hold individual stocks.

Removes investment choices. The beauty of automatic dividend reinvestment is the auto pilot feature—something is happening without you needing to do anything to make it happen once the plan has been established. What this means is that investment choices also become automatic. For example, in a rising stock market, dividend reinvestment will mean that stocks will grow as a percentage of your portfolio at an even faster rate than if you took the dividends in cash and invested it in bonds or money markets instead of in stocks. Automatic dividend reinvestment is an attractive option, but like other investment activities, it isn’t perfect. Consider all the advantages and disavantages it involves before deciding to participate in it.

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