Profit compounding is one of the most powerful forces that investors benefit from, over the long term. To get its full effect, investment income such as stock dividends and bond coupons should be reinvested. So much for theory. How should you go about it in practice?
I’ve written about the importance of compounding, and the concept of “doubling times” before. Readers interested in refreshing their memory will find more here.
Stock profits come from two sources: changes to the stock price (capital gains) and dividend income paid out as cash.
Many investors, such as those in retirement, rely on the dividend income to fund their day-to-day living expenses. Obviously, for that group, they can’t reinvest their dividends. Their stock portfolio will go up in value over time, from the capital gains. The income does its job paying for their lives, and also grows over time.
For people that don’t rely on that dividend stream to fund their spending – at least not yet – the cash will start building up, if it isn’t reinvested. Since cash is a low return asset in the long run, those investors should reinvest the dividends into more stocks if they want the best long term returns.
The question is how to go about this. Can and should it be automated, or should it be done manually?
In some countries, such as the US and UK, certain companies offer what’s known as Dividend ReInvestment Programs, or “DRIPs”. The idea is that a shareholder can elect that all dividends paid by the company are automatically reinvested into more shares of the same company.
DRIPs are popular with many investors, where they’re available, although I have my reservations about them. DRIP programs are sometimes run by a company, and other times outsourced to an administrator, usually for a fee. A third alternative, where companies don’t offer their own DRIPs, is that some brokers will handle automatic reinvestment of dividends for their customers.
Advantages of DRIPs – whether company or broker run – include the following:
- They’re automatic, meaning the investor doesn’t have to do anything extra once they’re set up
- Sometimes, but not always, there are no fees or commissions charged on purchases (this doesn’t apply to broker schemes)
- Often they allow the purchase of part shares, and not just whole ones
- Sometimes, in company run schemes, there are price discounts available when the new stock is purchased. These can range from 1% to as much as 10%.
However, there are also substantial disadvantages:
- There’s extra paperwork and admin involved in setting up each DRIP, including being a registered shareholder (for company schemes)
- In company schemes, shares bought via a DRIP can only be sold back to the company. They’re less liquid than other shares and can only be sold at certain times.
- The dividends are still subject to income tax, although no cash is received to cover it. So the tax has to be covered from other sources of cash.
- Record keeping for tax purposes can be extremely complex.
That last point is extremely important, but often overlooked. When you eventually come to sell stocks you’ll need to know the “cost basis” of all shares bought, being what you paid for them. That’s because there will usually be capital gains tax to pay.
Let’s say you bought 15 stocks and each paid a quarterly dividend, which was automatically reinvested in more shares via a DRIP. After 10 years you’d have 615 individual share lots to track for tax purposes, being the 15 original purchases and 600 more from all the reinvested quarterly dividends (15 x 4 x 10).
That’s a hell of a lot of admin.
At the same time, at each point when dividends are reinvested via a DRIP, you don’t know whether you’re going to get a good or a bad price. In theory, it should average out in the end, as markets go through their cycles. But, at times, a stock could be expensive for a prolonged period, meaning the cash isn’t being used efficiently.
Overall, unless there’s a big price discount on offer, I’d say that DRIPs are best avoided.
So what should you do?
However, you should still monitor your dividend income and make sure it’s used to maximise your long term returns. This is best done by reviewing your overall portfolio from time to time, and making conscious decisions about which positions you want to top up (or reduce).
Every investor should do a full portfolio review at least once a year. That’s when they rebalance all their asset allocations, including their individual stock positions.
Some things should be reduced, because they’ve got too big and need to be diversified. Others should be added to, either because asset allocation targets have got out of whack or because the prices are still a bargain relative to value.
Dividend income makes up part of the overall cash balance. It may be appropriate to deploy it, in the context of overall asset allocations (my recommendations for allocations remains unchanged since August – see here). Or it may not. It will depend how all the positions have moved, relative to each other.
Of course, you could review the portfolio more regularly, say quarterly or once every six months. It’s entirely up to you. But once a year is usually enough for a full review.
The exception would be after there’s a market crash. That’s when you should get in there and use your cash “ammo” to scoop up some beaten-down bargains.
Here’s another way of looking at why once a year is frequent enough to check whether and how your dividend income should be reinvested.
A typical, diversified stock portfolio will yield 2% to 5% a year. Stocks are a subset of your overall financial investments, which will include various amounts of things like bonds, gold and cash.
If you have 40% in stocks (my current recommendation), that means the dividend yield as a percentage of the total portfolio will be 0.8% to 2% a year. If you have 80% in stocks, it’s likely to be in the 1.6% to 4% range.
Your total portfolio could move by that much in a single day, and certainly over a week or a month. So why the huge rush to reinvestment dividends on the very day the cash is received?
I don’t think there’s any need. Once a year is enough in most circumstances.
Of course, if you have a particularly high income portfolio, or particularly high allocation to stocks, then taking a closer look more frequently makes sense. But even then, once every six months should be enough, and certainly no more often than once a quarter.
Reinvestment of dividends is essential for investors looking to maximise long term returns from profit compounding. But it’s best done following conscious decisions to top up the best opportunities, not via automated schemes such as DRIPs.
For most people, it’s enough to review of the situation once a year. That’s in the context of a broader portfolio review, which you should always do anyway.
Do reinvest your dividends when it makes sense. But don’t let it stress you out. Relax. You have plenty of time.
Stay tuned OfWealthers,