If you are an investor who owns individual stocks or ETF’s, then you’re likely to receive dividends from some of them on a regular basis. Should dividends be reinvested is therefore one of the most commonly asked questions in the community.
And when you are a starter, it might be confusing what to do with your dividend payments. As an example, many traditional brokers will prompt you to make a choice, but how do you know what to chose?
Will you take the dividend as cash or reinvest it directly back into the stock or the ETF?
In my case, dividend investing is at the core of my investing strategy, because one day I would love to live off the dividends my investment portfolio generates.
That’s why, as a dividend investor, one of the first fundamental questions I had to answer is: should dividends be reinvested?
Before I will answer that question, let’s start with some important basics first.
As a shareholder, you are a part-owner of a company. If the company makes a profit and has excess cash, then it has few options to consider:
- Reinvest its cash back into the business
- Pay-down debt
- Increase the ownership of existing shareholders by buying back shares
- Pay shareholders a dividend to reward them for their investments on a per-share basis
The option it choses has a lot to do with their capital allocation strategy. Some companies focus more on accelerating sales growth by investing most of the cash back into the business, while others focus more on shareholder enrichment via buybacks and dividends.
There is no good or wrong here, it mostly depends on where the company is in their lifecycle and on their ability to generate excess cash in the years to come.
So to sum it up, a dividend is a distribution of profits by a corporation to its shareholders
What are ex dividends and why are they important
In the US, dividends are mostly paid out on a quarterly basis, while in Europe this happens rather on a bi-annual or annual basis. The differences between the two continents have a lot to do with corporate culture and expectations from their investors.
But they have one thing in common and that’s their announcement of the dividends. This typically happens at the time the annual reports are published or via individual press releases.
What you will observe is such an announcement is that there are 4 different dates communicated:
1. Declaration date
The day the board of directors announces the distribution of a dividend. This also means an official obligation to pay the dividend to its shareholders.
2. Ex Dividend date
This is officially the first day that a stock trades without a dividend. Purchasers of shares on or after the ex-dividend date are not entitled to a dividend, so it’s important to purchase shares the day before in case you want to collect the dividend.
3. Record date
The day on which the investor must be on the company’s books to be eligible for a dividend. This sounds confusing in comparison to the ex dividend date. That’s because the ex dividend date is set by the stock exchange, not the company. They both need 1 to 3 days to settle for the stock trades, hence the typical 3 days difference in between.
4. Pay date
The day the dividend is paid by the company to its intermediates and shareholders. Sometimes you will receive the dividend few days later depending on your broker. This applies especially to brokers which support trading in fractional shares. It just takes some time for them to process those dividends and distribute them correctly to all the shareholders on their platform.
Looking at these dates tells us that the ex dividends are most important to shareholders, because that’s the only real date that decides whether we will receive a dividend or not.
Now that we know this, let’s get back to the main topic of this article: should dividends be reinvested?
The single best reason to reinvest dividends
When reinvesting dividends you get the ultimate benefit of compounding.
Just take a look at the example below in which I compared the S&P500 normalized return vs the S&P 500 Total Return (it means dividends reinvested):
This is really a major difference and it only gets bigger as time passes by.
This is a great example of why Albert Einstein seemingly called compound interest “the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
So in its essence, dividend reinvesting really fuels the compounding effect of your stock portfolio.
Having said that, in some countries there may be a tax advantage by investing in a dividend total return ETF, meaning an ETF that automatically reinvests the dividends instead of distributing the cash.
This is for instance the case in the Netherlands where shareholders don’t pay tax on capital gains but do pay 15% withholding tax on dividends.
Calculate the impact of dividend investing to your own situation with my dividend reinvestment calculator.
When dividend reinvesting doesn’t make sense
The only reasons I can think of is when you are near or at retirement, when you want to retire early or when you want to take the cash to “buy some free time”.
Those are the moments where you get to really benefit from all the discipline and patience you have shown as a dividend investor over the years.
In the first case you will probably get a pension in which case you can add the dividend income to live a wealthier life.
In the second case your dividends are already covering your expenses. That’s the moment where you can decide to stop working for money and that’s something we typically call financial independence, retire early (FIRE).
In the last case you would be looking for working less to improve the quality of your life. Not everyone wants to retire early, but maybe just work less (i.e. 24 hours a week). This would give you more time to spend on the things you enjoy doing, i.e. being with your family or certain time consuming hobbies.
How does dividend reinvestment work?
Dividends come in two forms: cash or stock. Often you can chose which you prefer as a shareholder.
That’s why there are typically two different dividend reinvestment strategies dividend investors use. However, you can use these interchangeably.
1. Stock dividend reinvestment
A stock dividend reinvestment is a direct transaction to increase your share count. The benefits of such a dividend reinvestment strategy are:
- It’s relatively cheap, because usually you pay none to almost no transaction fees
- It can be automated, which makes it easy and avoids a lot of psychological biases
- It is consistent, because you receive additional shares on a regular basis. This is a great example of dollar cost averaging.
Not selecting stock dividends could be considered when the underlying company is performing poorly or when your position size reaches its maximum.
Not every stock broker provides European investors with the option to chose stock dividends as a reinvestment option. However, Interactive Brokers provides this option to citizens with a brokerage account in the UK.
Another option is to use Trading 212 which allows you to turn on the option of automatic dividend reinvestment. Technically those are not stock dividends, but it comes at no additional costs and it reinvests the whole dividend in fractional shares.
2. Cash dividend reinvestment
A cash dividend reinvestment is a strategy in which you take the cash and redeploy it elsewhere, i.e. with your next stock purchase. This is another form of dollar cost averaging and it ensures that you avoid timing the market.
The benefit of such a dividend reinvestment strategy are:
- The freedom to reinvest the dividends in other (undervalued) stocks of your own preference
- It allows you to save up some cash in case you think that the market is about to turn south (I personally don’t like market timing, but some people feel more comfortable with this)
- It allows you to better diversify by taking dividends in cash and adding to another position you already have
Taking the dividend payments in cash as a dividend reinvestment strategy is something you often see recommended by value investing oriented dividend growth investors.
What about dividend reinvestment plans (DRIP)?
So far I have described the strategies for reinvesting dividends yourself. However, many companies offer the option of using their dividend reinvestment plans (DRIP) to simplify the process.
That’s where the term DRIP comes from which is especially popular in the United States. These plans are less popular in Europe, because there are only few companies that offer those, i.e. Unilever and Halma Plc from the Noble 30 index.
Traditional benefits of such DRIP plans are, but not always, discounted share prices, commission-free transactions and fractional shares.
But as mentioned before, this is nowadays also possible via brokers like RobinHood, M1 Finance or in Europe via Trading 212. Hence why I find these dividend reinvestment plans currently a bit outdated for the regular home-gamer.
My verdict: should dividends be reinvested?
To answer the question should dividends be reinvestment is actually quite easy for me.
In my opinion and based on the information shared earlier, dividends should always be reinvested when you’re still in the accumulation phase.
I strongly believe time in the market beats timing the market, hence there’s no need to set money aside to wait for a down turn. Just so you know, I’m already waiting for a proper downturn since 2014 and the covid19 market crash was over in the blink of an eye.
In my opinion, the only question remains is to take the dividend payments in stock or cash. The choice you make has more to do with your personal investment style. Do you prefer an easy automated process or do you prefer buying stocks at a discounted price?
How I reinvest my dividends
I automate dividend reinvesting wherever possible. I have limited options available, because I can do this only for Dutch stocks at my Dutch brokerage account or at Trading 212.
The mistake I often make is to wait too long before reinvesting my dividends. In this context you could say that I’m my worst enemy in trying to achieve my goals according to my retirement plan.
In all other cases I therefore add the received cash dividends to my monthly purchases to benefit the most from dollar cost averaging.
And now I’m curious to hear from you, what do you think: should dividends be reinvested? And if so, what’s your personal dividend reinvestment strategy?
I’m looking forward to read some of your answers in the comments below.
European Dividend Growth Investor
I’m not a certified financial planner/advisor nor a certified financial analyst nor an economist nor a CPA nor an accountant nor a lawyer. I’m not a finance professional through formal education. I’m a person who believes and takes pride in a sense of freedom, satisfaction, fulfillment and empowerment that I get from being financially competent and being conscious managing my personal money. The contents on this blog are for informational and entertainment purposes only and does not constitute financial, accounting, or legal advice. I can’t promise that the information shared on my blog is appropriate for you or anyone else. By reading this blog, you agree to hold me harmless from any ramifications, financial or otherwise, that occur to you as a result of acting on information provided on this blog.