What Should You Do With Your Dividends?
Recently a reader asked me What do you do with dividends? There are so many options. Can you narrow it down to a few good ones? I think this is an important question and many investors don’t pay enough attention to the impact dividends can have on a portfolio. In a nutshell, dividends are payments made by a company to owners of the company’s stock. When you receive dividends, you have two major choices to make; (a) take cash or (b) reinvest your dividends. Dividend reinvestment can really help you build wealth and the argument in favor is very compelling. However, there may be reasons why dividend reinvestment is not the preferred choice for everyone. Let’s first take a look at the major advantages of dividend reinvestment.
Reasons to Reinvest Your Dividends
- Investment Cost Savings. Dividend reinvestment is automatic, so your investment is free of commissions or fees.
- Simplicity. Once you set up dividend reinvestment through your broker, it’s automatic (set it and forget it)!
- Flexibility. You can buy fractional shares with dividend reinvestments. You can’t do this when you buy stock outside of a dividend reinvestment plan.
- Regularity. Dividend reinvestment allows you to invest periodically with dollar-cost-averaging being one of the major benefits of this process.
- Wealth Accumulation. I believe it is Albert Einstein who once said “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” If compound interest is the eighth wonder of the world, the compounding effect of dividend reinvestments should be the 9th Dividend reinvestment allows your dividends to buy more shares, which gives you more dividends going forward, which then allows you to buy more shares and so on. The wealth accumulation due to reinvesting your dividends cannot be understated. As the graph below shows, the financial impact of reinvesting vs. not reinvesting dividends in the S&P500 Index is significant and becomes enormous over time.
Reasons to Take Cash
Nonetheless, the are several reasons why you may decide to take cash instead of reinvesting your dividends. These include
- Income needs. You may be in retirement and have expenses that you need to cover. After considering other sources of income, dividends may help to cover an expense gap you need to fill.
- Diversification. You may be overweight in a particular investment that pays dividends and want to find other opportunities to reduce your portfolio risk. If you are short on cash, you can dividend payments offer an opportunity to diversify your portfolio.
- Poor Performance. If an investment is not meeting expectations, dividends are getting cut and/or you are not getting that compounding effect from your dividend reinvestments, you may not want to reinvest your dividends and instead, look for other opportunities. However, if this is the case, you should seriously consider selling the entirety of such an investment that underperforms.
The key point is that each investor will have a unique situation that will drive the decision to reinvest dividends or take cash. There are major advantages to reinvesting dividends that are extremely compelling, especially if you have plenty of time to stay invested. However, you may need the cash or find alternative investments because of your existing financial condition. Consider speaking with a financial advisor to determine the best option for you. Until next time.
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