Thursday, September 29, 2016

Dividend Reinvestment – Automatic versus Manual

There are two schools of thought when it comes to dividend reinvestment. One of the options is to automatically reinvest dividends, whereas the other option is to selectively reinvest dividends received.

The automatic dividend reinvestment is the easiest one to do. Once you purchase a dividend paying stock, you essentially check the “dividend reinvestment” box. As a result, your dividend income is reinvested into more shares of the same stock, and you start the income compounding process. The set it and forget it type of action is particularly appealing to income investors who are just starting out and have small amounts to invest in the beginning,

Because of the fact that it is free, automatic reinvestment into more stock is most efficient for those investors. Otherwise, even at $4-$5/trade, reinvesting anything less than $800-$1000 in dividend income would be prohibitively expensive. In addition, some companies offer DRIP discounts for shareholders who automatically reinvest distributions back into more stock. Unfortunately, even if you reinvest dividends back into the same stock that paid them in a taxable brokerage account, you still owe taxes to the IRS, depending on your income level.

If you are investing in a retirement account, where contribution amounts are limited, it may also make sense to reinvest automatically, regardless of valuation. This is because it would be more cost efficient to do so, rather than accumulating cash until it makes sense to make another investment from a cost standpoint.

The other option for income investors is to accumulate dividends in cash until a certain level of money is reached, and then buy shares in an attractively valued stock. The difference from automatic dividend reinvestment is that you take valuation into account, and do not mindlessly reinvest dividends. This way, you are not overpaying for future income, and could actually may be stacking odds of success in your favor. It does make a difference to long-term results if your future income is purchased at a lower price. Notice that the selective dividend reinvestment method does not mean that you should not reinvest dividends regularly – it just tells you to be mindful of valuations when reinvesting distributions.

While automatic dividend reinvestment does compound your income, it does not make much sense to automatically reinvest dividends into a security that sells for 30 times earnings for example. Right now, shares of Brown-Forman and Automatic Data Processing currently sell at over 25 times earnings, and offer low yields in the process. Investors in McCormick (MKC) , Brown-Forman (BF.B) or Automatic Data Processing (ADP) should be better off accumulating dividends in cash, and then reinvesting them in attractive opportunities selling below 20 times earnings. With the manual dividend reinvestment, you allocate your capital in the best opportunities at the moment. This reduces risk, since you can potentially end up investing those dividends in more new companies, which increases portfolio diversification. One downside for this method is that it is a little more time consuming than the first.

However, if your portfolio is not large enough, it might take you a lot of time before you accumulate enough dividend cash in order to allocate to a full position. I would not advise anyone to pay more than 0.50% in commissions when purchasing dividend paying stocks. Therefore, if you are paying a $5/trade commission, you should be spending at least $1000 per each position. If your portfolio value is $30,000, and it yields 3%, it might take you a little over one year before you can put that money to work. So there is an opportunity cost in waiting, as you might have been better off dripping automatically. This could be an issue for portfolios where no new money is going to be added. Once you reach critical mass in a portfolio, which is usually around $100,000, it could potentially self-fund 3 – 4 purchases/year, just from dividends alone.

For portfolios where you are still adding regular contributions however, you can simply combine your deposits with the dividends received. As part of a monthly process, you should have a criteria that would allow you to be searching for bargains, and then use that list to research those candidates. For those that meet your qualitative criteria, you should put them on your shopping list. Depending on the level of capital you can deploy, existing portfolio weights, you can then choose the ones on the list that make sense to be purchased.

In my taxable portfolio, I have always tried to accumulate dividends in cash, and then deploy them in the best ideas I have at the time. Over the past 8 - 9 years I always combined those dividends received with any deposits I put in my accounts. So in essence, I was still reinvesting those dividends, just not in the companies that paid them. I also managed to reinvest those dividends usually within 3 - 4 business days from receipt. This was possible because I was making several purchases per month with new deposits and dividends received.

Regular readers know that I have taxable and tax-deferred brokerage accounts. For those tax-deferred accounts where critical mass has not been achieved, I reinvest dividends automatically. This includes my legacy Roth IRA, where new money used to be deposited once per year. It is cost effective to do so.

If a Roth IRA reaches critical mass in a decade or so however, it may make sense to allocate the cash manually in the best opportunities I identify. Because of the constraints on the account, it made sense to automatically reinvest the dividends.  It would have been too costly to sit and wait for months, until I accumulate enough dividends to go ahead and manually put them to work.

In my 401 (k) account, I reinvest dividends automatically, because I am limited to the investment options there. I can only buy funds for now there.

The one important lesson to consider with dividend reinvestment is that you will pay taxes on dividends received in your taxable brokerage accounts, whether you reinvest them or spend them. As a result, you should consider whether it makes sense to put as much of your investment savings in tax-deferred accounts as possible. This could save money from taxes today, and any distributions you receive won’t be taxable until you start withdrawing the money. Therefore, if you are still in the accumulation phase today, and plan to be there for several years, try to determine if your target retirement date won’t be sooner if you used tax-deferred accounts.

To summarize, there are generally two methods to handle dividend reinvestment. Your decision to embrace either method will be dependent of different constraints such as account type, account size, valuations, whether you are contributing to an account and the level of involvement you are willing to allocate to your portfolio.

Full Disclosure: Long ADP, MKC, BF.B,

Relevant Articles:

Reinvest Dividends Selectively
Are Drips Worth It?
The Only Reason for Automatic Dividend Reinvestment
How to Generate an 11% Yield on Cost in 6 Years
Dividend Reinvestment is important

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