This article originally appeared on The DIV-Net October 3, 2008.
One of the components of every stock analysis I have done at my blog has always been to show the effects of dividend reinvestment over a ten year period of time. The results are truly amazing as the dividend income with reinvestment almost always outpaces the dividend income without reinvestment.
The main pro of re-investing your dividends is that you get the power of compounding in your favor. You are essentially getting “free shares” by investing the total dividend income into more stock. If you have also picked a solid stock that tends to increase the payments to stockholders every year you are essentially turbo charging your portfolio for the long run and should expect to receive even faster annual dividend raises.
Another reason for re-investing dividends is that one could dollar cost average their dividend income into more stock by spreading their purchases over a period of time, which also decreases risk.
The past decade was definitely a good time to be re-investing your dividends in Realty Income (O).
One con for dividend reinvestment is that you still get taxed on the income that you receive. Another thing that the investor holding stocks in a taxable account should do is keep a very through bookkeeping of their activities in order to efficiently file their tax returns for the year.
One of the major reasons why people are hesitant to do dividend reinvestment however could be that instead of purchasing new assets or enjoying their dividends, they are adding onto a single investment which could go bankrupt. Chances are your company might fail leaving you with a lot of shares which are trading at or close to zero, even after years of diligent reinvesting of dividends. Check out FRE, FNM and LEH for reference. With hindsight, investors in those former financial behemoths would have been better off putting their money in US long bonds.
Even if the company doesn’t fail, it could still eliminate its payments to shareholders, which leaves the investor without the dividend income that they were relying onto. GM, which has always been touted as a great barometer for the overall US economy is a recent example of this scenario (remember the saying “As goes GM so does the nation”).
So what should investors do about dividend reinvestment?
I believe that as long as the dividend investor holds a diversified portfolio of income producing instruments, they should be able to weather any industry specific related storms successfully and without losing all of their dividend income in the worst case scenario. The best strategy for this type of person would be to take maximum advantage of the power of compounding and re-invest their dividends.
On the other hand however, if you plan on living off your investments, you might want to hold off dividend re-investment and enjoy your money working for you.
I believe that the question of whether to re-invest your dividends or not is mostly a question of how diversified your portfolio is and when do you plan to use the dividend income that is generated by it.