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Robert Abbott
Robert Abbott
Articles (716)  | Author's Website |

Dividend Investing: Why Reinvest?

Reinvesting dividends is a good strategy for accumulating wealth and growing your holding with discounted shares

October 02, 2019

Reinvestment of dividends is the subject of this chapter, but before getting into it, we will briefly review the preceding chapter. It asked: “When is the best time to sell a dividend stock?”

I say “briefly review” because I found Kevin Lowe’s discussion on when to sell a dividend stock disappointing (it is chapter nine of “Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks”).

He offered three reasons for selling:

  1. If you “believe” a company’s stock is about to drop significantly. I put believe in quotes because taking any action based on belief is essentially speculation (and Lowe has written that speculation is not a good strategy). Second, a dividend strategy is usually about compounding over time, not trying to time the markets.
  2. If you “believe” the company has already lost its moat, also known as its competitive advantage. This I consider a valid reason to sell a stock; a loss of a competitive advantage means smaller margins and eventually smaller dividends (unless the company successfully implements a recovery plan).
  3. If the stock is selling above its fair value. This seems to me to be a growth strategy rather than a dividend strategy (see my explanations for reason number one above).

Overall, a chapter based on these assumptions provides little value to readers.

Turning to chapter 10, dividend reinvestment, Lowe drew a distinction between amateur and experienced investors. Amateurs, he wrote, are excited about receiving cash payouts, while on the other hand, experienced investors get excited about reinvesting their dividends rather than getting cash.

Before we run with that idea, I’d like to interject and suggest Lowe’s distinction is not complete. Yes, sometimes it does make sense to reinvest your dividends in the same company; however, there are many common situations in which you should take the cash.

For example, it may make sense to invest in new stocks, rather than continuing to build on the same stock. Using the dividend payment cash to buy other stocks will produce greater diversification.

Depending on your income or taxation levels, it may be better to take routine small dividend payments rather than taking it all in one big hit later. The same holds if you know there is a significant life transition ahead, something like returning to college or buying a new home.

Still, Lowe has it right on the broad principle of this practice: “Reinvesting your dividends is one of the best practices in stock dividend investing. Instead of cashing out, you can just reinvest your profits so you are gradually building your wealth.”

The most important of the reinvestment strategies is buying stocks that offer a dividend reinvestment program, or, DRIP. The companies offering DRIPs automatically convert the value of your dividend into new shares. The big advantage is the avoidance of commissions or fees. Avoiding these fees is the equivalent of receiving a discount on the share price.

There are three main types of DRIPs:

  • In-house programs: These are offered by the companies paying the dividends.
  • Third-party programs: Companies sometimes outsource their reinvestment plans to independent (and in some cases, specialist) companies that use transfer agents.
  • Brokerage programs: Stockbrokers also handle DRIPs, generally for clients with existing accounts. There is a price for these services, paid by investors or by the dividend companies.

Why would companies offer reinvestment programs? Lowe wrote, “Running reinvestment programs can provide a lot of benefits to companies that are regularly issuing dividends. In general, if the shares are acquired from the company through a reinvestment scheme, this will generate more capital for the business.”

Dividend companies also know that shareholders with DRIPs are stickier, which is to say they are less likely to sell their shares when the company faces temporary turbulence.

For investors, there may be an additional sweetener: Some companies offer discounts on share purchases, normally ranging between 1% and 10%. This discount plus avoiding brokerage fees can lead to attractive prices.

Many investors, though, think of the accumulation of wealth as the biggest benefit to DRIPs. Reinvestment allows them to compound their payouts and build wealth without necessarily buying additional shares. Time plus compounding is always good for investors.

Still, there are some disadvantages to reinvestments (beyond those flagged above). Your acquisition of new shares happens automatically, as soon as the dividend is nominally paid. That’s convenient, but if the company’s shares are wildly overvalued, you may be buying at a price that is too high to be sustainable.

According to Lowe, there may be an escape clause for this problem with some DRIPs. He wrote, “So always check if the reinvestment program has clear provisions on what you can do if you want to decline the offer and you prefer to cash out the dividends.”

Conclusion

Reinvestment programs, including DRIPs, can be a great way to build wealth. They allow investors to automatically convert their dividends into new shares, usually without paying brokerage fees or commissions (except, in some cases, when the broker also handles the distribution of dividends and reinvestments).

However, it’s not necessarily the optimal solution in all cases. For example, investors who want greater diversification are better off taking the cash and buying new stocks.

Companies also like dividend reinvestment plans for the simple reasons that they bring in new capital at practically no cost and tend to attract investors who are more likely to stick with it when it faces adverse circumstances.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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