Should You Reinvest Your Dividends?

First, let's define what dividend reinvestment is. When you invest in a company that pays dividends, you have the option to receive those dividends as a cash payment or to automatically reinvest them back into the company. By choosing to reinvest your dividends, you're essentially using them to buy more shares of the stock, which can help grow your portfolio faster.

So, if you invest in McDonalds and they pay you, you can then essentially say ‘I don’t want this cash, instead please buy more McDonalds stock’.
You can choose to buy back more shares of the company that paid you the dividend or you can use the payment to buy more shares in another company - either is great and increases your portfolio! 

Deciding to just buy the same company is easier and you can have this done automatically but picking which company yourself allows more flexibility and you can decide what you need more of in your portfolio - perhaps you need a higher exposure to a particular sector and a certain stock is trading at an attractive price and you want in on the action. 

Why is it important?

Compound Interest

Reinvesting dividends can be a powerful way to take advantage of compound interest, which is the concept of earning interest on your interest. When you reinvest your dividends, you are using your earnings to buy more shares of the underlying stock or fund. As a result, you can potentially earn dividends on your new shares, which can compound over time and increase your overall returns.

For example, let's say you own 100 shares of a stock that pays a £1 dividend per share. If you reinvest your dividends, you will use that £100 to buy more shares of the stock. The next time the stock pays dividends, you will receive dividends on your original 100 shares as well as your new shares. This process can repeat itself, potentially increasing your returns over time. This is not a straight line either, it compounds and increases exponentially!

It's important to keep in mind that compound interest can work both ways - if the value of your investments decreases, you may end up with fewer shares and lower returns. However, by reinvesting your dividends, you can potentially increase your chances of realising higher returns over the long term.

Three studies have found that dividend reinvestment can increase returns and boost income over the long term:

•  A study by T. Rowe Price found that reinvesting dividends can increase total returns by as much as 50% over a 20-year period. 

• A study by Vanguard found that reinvesting dividends increased total returns by approximately 2.5% per year. 

• And a study by Charles Schwab found that reinvesting dividends can increase annual income by as much as 20%. The study analysed the performance of the S&P 500 Index over a 20-year period and found that reinvesting dividends increased total returns by approximately 2% per year, compared to receiving dividends in cash.

It is powerful to see this graphically:

Source: https://mystockmarketbasics.com/should-i-reinvest-dividends/  https://mystockmarketbasics.com/should-i-reinvest-dividends/ 

• All three lines are of a $1000 portfolio invested over 30 years. 

• The blue line at the bottom represents a portfolio of stocks with no reinvestment, reaching $2000 over the period or a 2.3% annual return. 

• The red line is a portfolio of no-growth dividend stocks, reaching about $4,500 over the 30 years…that 5% annualised return is better and proves the power of dividend stocks but it’s nothing compared to investing in dividend stocks that grow the dividend AND reinvesting the payments!

• The green line is a portfolio of both dividend reinvestment AND dividend growth. That portfolio would reach $9,000 over the same period, a return of 7.5% a year.

Cost Averaging

By reinvesting your dividends, you're buying more shares of the stock at different price points. This is only really true is you sign up to a DRIP (dividend reinvestment plan) where your broker will automatically purchase more shares when the dividends come through or if you reinvest manually as soon as the dividend reaches your account. If you manually reinvest and decide to try to somewhat time the market this point may not be as valid.

Source: https://tokenist.com/investing/dollar-cost-averaging/

But anyway This can help reduce the overall risk of your portfolio and smooth out the impact of market fluctuations. For example, if you reinvest your dividends every month, you may end up buying shares at a lower price some months and a higher price in others. This can help you average out your cost per share and potentially improve your returns.

Increased Income

As your portfolio grows, you'll also be earning more dividends, which can further increase your income. 

Long-term focus

By choosing to reinvest your dividends rather than spending them, you're demonstrating a commitment to long-term investing. This can help you stay the course and not get swayed by short-term market fluctuations. A long-term perspective is important in investing, as it allows you to ride out market ups and downs and potentially achieve better returns over the long run.

Diversification

Dividend reinvestment can also help you diversify your portfolio by allowing you to invest in a variety of stocks and funds. This can further reduce risk and increase your chances of success. According to a study by financial firm Vanguard, a well-diversified portfolio can help you achieve better returns with less volatility.

When you may not reinvest dividends:

There are certain situations in which it may not be advisable to reinvest dividends. 

• Living off dividends: If you are relying on dividends to pay bills, such as in retirement, you may not want to reinvest them as you will need the income.

• Already reached financial goals: If you have already accumulated the amount of money you need to reach your financial goals, you may not need to reinvest dividends to achieve those goals.

• Overvalued or expensive stocks: If you believe that stock prices are overvalued or that an individual stock is too expensive, you may choose to hold onto your dividends rather than reinvesting them.

• Alternative investment opportunities: If you come across a particularly attractive investment opportunity, you may decide to allocate your dividends towards that opportunity instead of reinvesting them.

• Tax considerations: Depending on your tax situation, you may be better off receiving dividends in cash rather than reinvesting them.

As always, it's important to do your own research and consult with a financial advisor before making any investment decisions.

- May the dividends be ever in your favour!