1/13/08

Reinvesting Dividends -- Good Idea or Bad?

Investors sometimes wonder whether they should reinvest their stock and mutual fund dividends. I'd like to go through some of the advantages and drawbacks of doing so.

But first, what's a dividend anyway?

Usually a portion of a company's profits,* dividends come in three forms: stock, cash, and property. The two most common are stock and cash, with cash being the most popular. Sometimes distributed monthly, semi annually, or annually, the most common dividend distribution is quarterly. This depends on when the company's board of directors decides to declare a dividend.

Mutual funds are required by law to distribute most of their income and capital gains, which are usually taxed at different rates. They usually do so at the end of the year.

How do you get a dividend? In the case of both companies and mutual funds there is something called the ex-date. This is the date on which and after which the seller of the mutual fund or stock would be entitled to the dividend previously declared, but not the buyer. On and after this date, the stock or mutual fund is said to trade ex-dividend. Let's say the stock or mutual fund trades for $100 a share and there is a $1 a share declared dividend. On the ex-date, let's say the price as determined by trading, remains unchanged. Trading ex-dividend, that stock or mutual fund is now at $99 a share, the $1 having been taken off because of the dividend.

The ex-date is generally two or three days before the record date, which is the date established by the company or mutual fund declaring the dividend to determine who is entitled to receive the dividend on the payable date, when the company actually sends out the payment. How you receive the payment likely depends on how you purchased and hold the stock, for example directly from the company or through a broker. For instance, you may get a check in the mail from the company, or see the money deposited in your brokerage account.

If I've been unclear, this article may be helpful.


Reinvesting Stock Cash Dividends

By reinvesting, you get more shares in the company.

The Good:

1. If the stock goes down, you are automatically lowering your dollar cost per share because you are buying shares at a lower price. If the stock later goes up, you will break even more quickly and get more profits if it continues its assent than if you would if you did not reinvest your dividends. If the stock goes up, you are buying less shares. This is also good, as your average dollar cost does not go up as much. In other words, following the old adage "buy low, sell high," you are buying more when the stock is cheaper and less when it's more expensive. As you are not adding any extra money, that is, as all new shares are coming from your dividends, this is a good thing.

2. My favorite reason for reinvesting dividends is that it compounds your dividend payouts. Reinvesting gets you more shares, so your future dividends, as long as the company does not cut the payout, are larger.

For example, say you buy one share of a company for $100, and let's say the company pays out a quarterly dividend of $1 a share, giving out $4 a share per year in total. For the sake of ease, let's say this stock remains flat, trading at $100 a share for a year.

For the first quarterly dividend, you get $1 and reinvest it. (This example assumes you are buying the stock either directly from the company that allows fractional shares, or through a broker that has automatic free dividend reinvestment). As the stock remains at $100 a share, after reinvesting the $1, you now have 1.01 shares. That is, with that dollar, you've just bought 1/100 of a share.

For the second quarterly dividend, you get $1.01. That's because you received a dollar per share and have 1.01 shares. Once again, assuming the stock remains at $100 a share, if you reinvest it, you get an additional .0101 shares. You now have a total of 1.0201 shares.

When the third quarterly dividend comes around, you get $1.0201. Reinvesting this, again assuming the stock stays at $100, you get another .0102 shares, bringing your total to 1.0303 shares.

Your fourth quarterly dividend will be $1.0303. If the stock stays at $100, reinvesting this will get you an additional .0103 shares, bringing your total to 1.0406 shares.

So, starting off the year with one share, at the end you have 1.0406, without putting in any extra money. Had you not reinvested the dividends, you would have gained $4. Having reinvested the dividends, the total payouts received from the company amounted to $4.0604. That's a 1.5% greater return by doing nothing. Looking at it another way, not reinvesting the dividends would give you a 4% yield on the stock. Reinvesting them would give you a 4.06% yield. These sums are tiny, sure, but imagine this process with many shares and over a greater period of time.

As I've repeated, the example assumes that the stock remains flat. Had the share price fallen and you reinvested your dividends, your payout would be greater still. Had the share price risen, your payout would be smaller than in the example, but still larger than if you didn't reinvest the dividends.

As long as the company does not cut its dividend payout, reinvesting dividends compounds your dividend returns. When you retire and decide to start collecting your dividends, you'll find that your original yield has skyrocketed. Your payouts may eventually be greater than your original investment! Even factoring in inflation, which the article in the preceding link does not do.

3. According to one of the Motley Fool's many other infomercials on the subject, which I love to read, from January 1926 to December 2006, "41% of the S&P 500's total return" came from dividend reinvestment. As another example, also from Motley Fool, by investing $2000 in Pepsico (PEP) in 1980 and reinvesting dividends, you'd have $150,000 today. Doing the same with Philip Morris (now Altria) (MO), you'd have about $300,000 today.

4. If you do it manually, dividend reinvestment encourages discipline. You're buying more shares dispassionately, in accordance with a previously well thought out plan.

5. If you have it set on automatic, you're getting more shares without thinking about it.

The Bad:

1. Reinvesting dividends in a company that goes out of business or whose stock tanks is pretty bad. If you hadn't reinvested, your loses would be lower, because you'd have gotten some of your money back through dividends.

2. Reinvesting dividends can create a nightmare at tax time when you decide to sell all your shares. This is because you will have many purchases, all with a different cost basis. Depending on how long and how often you've been doing the reinvesting, it can be a lot of work to figure out your gains and losses at tax time. This doesn't apply to tax deferred accounts such as IRAs.

3. Reinvesting dividends in an all stock portfolio may make it too concentrated. You might want to think about using the dividends toward the purchase of some other asset class, such as bonds or commodities.

4. Similarly, reinvesting dividends may deprive you of cash you could use in a better way. That is, there are opportunity costs, and you may get a better return by using the dividend in some other way. Perhaps when deciding to reinvest dividends, you should think about whether you can do something better with that money instead. If you cannot, you should reinvest.

Reinvesting Dividends In Mutual Funds

The good and bad here are pretty much the same as above. There is, however, something to consider.

Stock prices fluctuate throughout the trading day. Mutual funds, on the other hand, are priced at the end of the trading day. This is determined by the market value of the mutual fund's net assets, divided by the number of outstanding shares. It's called net asset value (NAV).

People use many different ways of evaluating stocks, including share price divided by earnings (P/E), sales divided by earnings, etc. When a stock goes ex-div, its price drops by the corresponding dividend. The P/E falls, as do most other measures of the stock's value, making it look cheaper to investors. This does not happen with a mutual fund, as the cash distributed as a dividend lowers its NAV.

In other words, as a stock's price depends on the buying and selling of it, the dividend payout does not affect the stock's price as much as it does a mutual fund's. While a mutual fund's NAV depends somewhat on the amount of cash it has, most of its price movement comes from the market value of its other assets--stocks, bonds, etc. What this basically means, if it means anything, is that reinvesting a mutual fund's dividends gets you to the same position you would have been in if there were no dividend. You get more shares, but they are worth less than before. The same can be said with a stock, as in my reinvesting example above, but since a stock's price does not depend on net asset value, after dividend reinvestment your total position could be worth more than it was before the dividend. Of course, it could be worth less as well. Is this good or bad? I don't know, but it's something to consider.

As an aside note, unless you are doing this in a tax deferred account, you should avoid buying mutual funds at the end of the year before the ex-date. This is because you'll be taxed on the dividend, but won't have participated in the gains throughout the year.

Exchange Traded Funds (ETFs) and Closed End Funds (CEFs)

As these trade like stocks, even though their NAVs are calculated at the end of the day, reinvesting in them is much like reinvesting in stocks.

One thing to be aware of is that dividends from these, especially from CEFs, are sometimes taxed at different rates. Usually, most dividends are taxed at long term capital gain rates, but occasionally, depending on the fund's turnover rate and investments, a percentage of the dividend may be taxed as short term capital gain or ordinary income.

Additional Considerations

Some companies and closed end funds offer investors a choice between cash and stock dividends. If you're going to reinvest anyway, stock dividends are probably better. While still taxed, these are often given at a discount to the market price. For example, the share price might be $100, but your stock dividend gets you shares at $98. That's a pretty good deal. My position in Royce Focus Trust (FUND), a CEF focused on international small caps, gives me this option. An example of a company that gives investors a choice between cash and additional stock is HSBC.

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If you're interested in looking at what the dollar was worth in years past, adjusted for inflation, go here or here.

If you're interested in what a stock or ETF investment would be worth with and without dividend reinvestment, Sharebuilder has a neat tool, which goes as far back as 1996. (Where it says "get a quote," enter the stock you're interested in, and to the right of that, select charts. Click on "go." Then click on the link that says "What if I Had Invested.") One thing the tool lacks which would be helpful is showing the total amount of dividends you would've received. Nonetheless, it's pretty useful.


*This is not always the case since sometimes unprofitable companies give dividends.