Friday, April 11, 2014

How to deal with new cash from dividend payments

As a dividend investor, you have the luxury of receiving regular cash infusions into your portfolio on a regular basis. During the accumulation stage, you will also have extra cash that you would need to deploy on a regular basis. Even once you become retired however, you might still find a trickle of excess cash finding its way to your bank accounts, that you might decide to put to work in your dividend portfolio. You then have the opportunity to deploy this cash in one of two ways that you believe are the most optimal for your portfolio. The two options are to reinvest automatically (DRIP), or reinvest manually. Another option could be to mix and match both strategies.

Each of those strategies has its pros and cons. The major negative about DRIPing is that investors risk reinvesting distributions into shares without regards to valuation or opportunity cost. It could be very costly in the long run, if you mindlessly allocate dividends received into the overvalued companies that generated them, particularly if more attractive places for this cash are available. This is one of the reasons why I usually combine new cash with dividends received every month, and then make a purchase in my best ideas at the time.

One of the positives of DRIPs is that you are taking immediate advantage of the power of compounding, by putting cash dividends received into more shares right away. That way, you are not wasting time trying to accumulate enough cash so that it is cost effective to make an investment. Plus, you can set it and forget it, and take a more passive approach to compounding your wealth and passive income.

Another advantage of automatic dividend reinvestment is that you are not charged a commission when putting money back into the same stock that distributed cash for you. I do not advise anyone to pay more than a 0.50% in commissions before investing in dividend paying stocks. If you lose a portion of dividend income to excessive brokerage fees, you are shooting your compounding process in the foot. This is why automatic dividend reinvestment is ideal for situations where your dividend income is low, or you cannot add money to this account, in order to justify waiting for a set amount of capital to accumulate in cash.

I only reinvest dividends automatically for my Roth IRA account, which I started in 2013. This is because I can only put $5,500 per year in it, and the amount of dividend income generated per year is a couple hundred dollars. Therefore, it is not cost effective to wait for cash to accumulate and pay an exorbitant commission of over 2%, which would stump the turbocharging effect of growing dividends that are being reinvested. It is much better to reinvest dividends back into the company that paid them for free, rather than taking the time and paying a steep fee in order to reinvest elsewhere. Manual dividend reinvestment is quite inefficient for smaller portfolios with no new additions of capital. For my taxable portfolios, which are the lions share of everything however, dividends are reinvested selectively.

Full Disclosure: None

Relevant Articles:

How to be a successful dividend investor
How to identify your dividend investment goals
Where to search for investment opportunities?
When to buy dividend paying stocks?
How to analyze investment opportunities

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