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, investing in something else, etc. 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 called Money Boss.

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 “it’s so important to reinvest”.  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

Mindful investors can’t resist digging deeper to see if there’s a catch.  The catch is that most articles you’ll find on the internet extolling reinvesting don’t address the issue of costs.  And so far, none of the calculations above include the costs of reinvesting.  What if we add some sort of transaction costs into these calculations?  Nowadays a typical online trading fee at a discount brokerage might be $10 per transaction.  So, what happens when that 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 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.

Just to drive home the point, here’s a bar graph comparing the end results of each of these four scenarios.

When transaction costs are included (first and third bars from the left), annual reinvesting produces a 41% greater end value than monthly reinvesting over this 147 year period.  The power of compounding applies to costs as well.

Reducing reinvesting costs

It’s clear we want to minimize reinvesting costs, just like we want to reduce investing costs in general.  Fortunately, there are many tactics available to control reinvesting costs.

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 stock funds that pay monthly, but they’re less common.  So, the main options are to reinvest quarterly, semi-annually, annually, or every few years.

With reinvesting costs included, quarterly reinvesting will produce results somewhere between the annual and monthly examples presented above.  Investing every few years will generally underperform annual reinvesting, because the costs aren’t huge using either method, and reinvesting infrequently degrades your compounding power.  Consequently, the most mindful reinvestment approach that balances costs with performance is something close to an annual frequency.  But that decision is also dependent on how large your transaction costs are relative to the value being reinvested each time, as discussed next.

Cost Minimization – If you must pay 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.  One of the oldest is DRIPs (Dividend Reinvestment Plans).  Many companies offer DRIP plans 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.  So, read the fine print carefully and use DRIPs that are 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, or pick the lowest cost broker and/or fund available that fits your investing plans.  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.

If you’ve successfully eliminated costs through one of these tactics, you should favor reinvesting as soon as the dividends or income are paid, which will increase the rate of your compounding.  That usually means reinvesting quarterly for dividends and semi-annually for bonds.  And once you’ve set them up, the automatic reinvesting features require no thought or action on your part, which is a great service.  I set up free automated reinvesting for my retirement accounts in about 10 minutes by checking a few boxes on the brokerage website.

Rebalance InsteadIn Article 8.7, I explored the nuances of rebalancing.  I showed that rebalancing is generally overrated but can be beneficial in some situations.  As noted in that article, if you need to rebalance, it’s important to minimize the costs of that process too.  One cost minimization tactic is to use dividends or other income to make the new purchases needed to rebalance your portfolio.  That way, you avoid any selling costs and only have the buy-side transaction cost.

Tax Minimization – Dividends and bond income 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 usually a mindful investing decision.  Regular reinvestment can significantly boost your long-term returns, if you stay clear of pitfalls with the following rules-of-thumb:

  • If you have transaction costs
    • Don’t reinvest too frequently. Once a year is a pretty good sweet spot.
    • Keep the cost of each transaction to less than half a percent of the reinvestment value; the lower the better.
    • Conduct any needed rebalancing with dividends or income as much as possible.
  • Otherwise, look for ways to reduce or eliminate reinvesting costs by using:
    • DRIPs
    • Brokerages and/or funds with free and automatic reinvestment services
    • 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 regularly, assuming you won’t be using dividends and other income for retirement or similar spending needs.  If you have access to a no-cost option, you should reinvest as frequently as possible to further boost the power of your compounding.