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8.8 Reinvesting dividends and income

This is the last article in the Investing Over Time series.  The final issue to tackle is how to use dividends and interest income as it accumulates in your investing accounts over time.  You have two basic options:

  1. Reinvest dividends and interest in the stocks, bonds, or other investments that generated the income.
  2. Apply the income to something else, like spending, or investing in something else.  Add your favorite idea here.

Given everyone’s financial situation is different, I can’t help you much with the second option.  For all I know, perhaps you desperately need that next dividend check to pay off your loan shark before he breaks your legs.  You’re probably the only person in the world who can decide at any given moment whether income can be better used for something other than investing.  So, this article is confined to the pros and cons of the first option, under the assumption that the main reason you’re even reading this article is to maximize the return on your investments.

Throughout past Mindfully Investing articles we’ve found time and again that one key to better investing is minimizing costs.  The same is true with reinvesting.  If you can reinvest at little or no added cost, the greater the potential benefits.  Conversely, the higher the costs associated with reinvesting, the less beneficial it becomes.

Of course, as a mindful investor, you should require evidence supporting the link between costs and reinvesting, which I’ll supply later in this article.  But first, we need to explore the potential benefits of reinvesting.

The case for reinvesting

Like so many investing issues, the benefits of reinvesting are propelled by math that seems relatively simple, at least on the surface.  In this case, it’s the math of compounding that makes reinvesting appealing.  Many articles have been written about how compounding works and how much of a difference it can make to investment growth over long time periods.  Here’s a pretty good example from the blogger J.D. Roth.

So, I’m not going to re-explain the math of compounding.  Instead, let’s look at an example of the results of compounding.  This graph compares the growth of one dollar invested in the S&P 500 with and without reinvesting dividends.

If you always paid your dividends to your loan shark instead of reinvesting them, one dollar invested in the S&P 500 in 1871 would now be worth over $600.  A 600-fold return is certainly not a bad outcome.  But that same dollar would now be worth over $300,000 had you instead used the dividends to buy additional S&P 500 shares every year.  This example uses stocks, but compounding investment growth by reinvesting income regularly works the same way for bond interest, savings account interest, certificates of deposit, etc.

This simple math is the reason why it’s so easy to find internet articles with headlines like “reinvesting is one of the smartest investing moves”.  Like some of those articles, I’ve purposely exaggerated the effects of compounding by using the full 147-year history of the S&P 500.  While no individual investor is going to be investing for that long, compounding still adds substantially to returns in periods as short as 10 years.  The first 10 years in the graph above is a good example.  If you’re still not convinced, you can calculate average annual return and final portfolio value for any period of the S&P 500 both with and without dividends reinvested at this Money Chimp page.  (You might get some results slightly different from those shown above due to small calculation differences, but you’ll be in the same ballpark.)

Reinvesting frequency

One thing that’s often glossed over is how often you should reinvest.  The above example assumes that dividends are used to purchase new stock at the end of every year (annually).  What if you reinvest monthly instead?  Here’s a comparison of annual vs. monthly reinvestment using the same S&P 500 set up starting in 1871, but focusing on just the last 17 years (since 2000).

You get an additional $50,000 dollars using the more frequent monthly reinvestment approach.  This suggests you should reinvest as frequently as possible, but not so fast.

Reinvesting costs

So far, none of the calculations above include the costs of reinvesting.  Until very recently, a typical online trading fee at a discount brokerage might be $10 per transaction.  So, what happens when that kind of cost is included?  Here’s a graph showing the last few years of growth of a larger investment in S&P 500 stocks ($1,000 in this case), again starting way back in 1871.

I used a $1,000 initial investment to keep the transaction costs reasonably proportional to the investment.  (That’s because nobody’s going to pay $10 to invest in a dollar’s worth of stocks.)  For the same reason, I used a $10 cost per reinvesting event for all dates after 1900, but only a $1 cost per event prior to that date.

Given the larger initial investment, the dollar values in the graph get huge by the time we reach the last couple of decades, which illustrates the miracle of compounding.  More importantly, we can see that the monthly reinvesting approach, which was previously so appealing when ignoring costs, is actually the worst performer when the relatively small $10 transaction costs are included in the calculation.  Conversely, annual reinvesting costs are much less of a drag on investment performance.

Reducing reinvesting costs

It’s clear we want to minimize reinvesting costs, just like we want to reduce investing costs in general.  Fortunately, with the rise of no-fee transactions, there’s really no excuse for paying reinvesting costs in most types of investing accounts.

Frequency – We’ve already seen that reinvesting too often can be counterproductive if you’re paying for each transaction.  Although monthly reinvesting is often used in compounding calculations, reinvesting monthly isn’t even an option in most cases.  Most stock ETFs and mutual funds pay dividends quarterly and many bonds and bond funds pay interest semi-annually.  There are some funds that pay monthly, but they’re less common.  So, the main options are to reinvest quarterly, semi-annually, annually, or every few years.

Assuming you’re investing in an account that charges no reinvesting fees, the more frequently you reinvest, the more your account value will compound.  Thus, quarterly reinvesting is the best realistic option because most stock and bond funds don’t pay dividends or interest any more frequently than this.

Cost Minimization – If you can’t find an alternative to paying for transactions, it’s best to keep the cost of each transaction proportionally small as compared to the amount being reinvested.  So, if you have $100 dollars of dividends at the end of the year, it’s cost-prohibitive to reinvest that money at $10 dollars per event, which equates to a 10% cost level.  There’s no hard and fast rule, but in general, it makes sense to keep costs below a half a percent to minimize cost drag on a portfolio.  Obviously, the lower you can drive that cost percentage, the better your performance will be.  But if costs are causing you to wait several years before accumulating enough dividends or interest to reinvest, you’ll need to consider one or more of the next tactics.

Cost Elimination – There are several options for eliminating the costs of reinvesting entirely.  I’ve already mentioned taxable and tax-advantaged brokerage accounts that charge zero transaction fees.  However, it’s worth noting that most of these brokerages still have hidden costs associated with each transaction.  The main hidden cost is that the brokerage gives you a fund share price that’s a little bit higher than the true market price.  They can then cash in on the difference between these two prices using nearly instantaneous computer trades.  But because it’s pretty much impossible to estimate how much this costs you over the long run, you might as well forget that these hidden costs exist and simply take advantage of these otherwise free transactions.

Another much older cost elimination option is a DRIP (a Dividend Reinvestment Plan).  Many companies offer DRIPs where dividends from individual company stocks are automatically reinvested in that same stock at little or usually, no cost.  However, there can be hidden costs with some DRIPs as well.  So, read the fine print carefully and use DRIPs that are completely free.

Because investing in low-cost stock index funds is the most mindful investing approach, DRIPs of individual company stocks may not be a useful option.  Thankfully, many online brokerages include free automatic dividend reinvesting for a wide array of ETFs and mutual funds.  Again, read the fine print to make sure it’s really free.  Similarly, most 401K plans automatically reinvest dividends in the investment selections you’ve made.  While 401Ks have sometimes substantial costs, there is normally no added cost associated with this automatic reinvestment process.  Besides being free, these automated reinvestment options are great service because you don’t have to remember to log in to your account every quarter and reinvest manually.  I set up free automated reinvesting for my retirement accounts in about 10 minutes by checking a few boxes on the brokerage website.

Tax Minimization – Bond income and stock dividends are taxed if they’re from investments held in a taxable account.  Qualified dividends are taxed at a special rate, and many types of bond income are taxed as ordinary income.  There are certainly ways to reduce the taxes you pay on dividends and other income, but that’s a subject for another day, given we’re focused on reinvesting.  From a reinvestment perspective, you want to avoid accidentally causing any additional taxes due to reinvestment transactions.  One trap to avoid is triggering the so-called “wash sales” rule.  Essentially, when you sell a stock or fund at a loss, that loss is no longer tax-deductible, if you then buy the same fund (or a “substantially identical” fund) again within a period of 30 days.  Automated reinvesting can easily run afoul of this issue.  For example, if you sell one lot of a fund to realize a tax break for the year and the same fund is automatically bought in the same month as part of your reinvestment process, you can no longer claim the loss.  And obviously, there aren’t any immediate reinvestment tax issues if you’re working in a tax-advantaged account.

Conclusions

With some simple planning and care, reinvesting dividends and income is a mindful investing decision.  Regular reinvestment can significantly boost your long-term returns if you stay clear of pitfalls with these rules-of-thumb.

  • Seek out free or very low-cost reinvestment transaction options wherever possible including:
    • Zero-fee transaction brokerage accounts
    • Automated free reinvesting with DRIPs
    • Automated free reinvesting offered by many brokerages and funds
    • A 401K plan or similar that reinvests with no added costs.
  • Temporarily halt any automated reinvestments in funds you’ve recently sold at a loss to maintain your tax break.

If you can’t avoid costs entirely, reinvesting too frequently will simply degrade the compounding you’re trying to achieve and should be avoided.  Usually, there is some way to reduce or eliminate reinvesting costs for most individual investors.  So, the mindful conclusion is that you typically should reinvest quarterly, assuming you won’t be using dividends and other income for retirement or similar spending needs.