Rethinking Automatic Dividend Reinvestment – Is there a Better Way?

In my last blog post we saw how reinvesting dividends can potentially have a large impact on a portfolio over time.  Does it logically follow that one should automatically reinvest dividends?  The answer is less clear than it first may appear.  In this blog post I will briefly look at the case for and against automatic reinvestment and discuss a third approach – the concept of manual dividend reinvestment.

The Case for Automatic Dividend Reinvestment

The premise is simple – by automatically reinvesting dividends, an investor can increase the shares they own, increase their future dividend income and have a larger base for future capital appreciation.  In most cases, reinvestment can be done without transaction costs (note: this is an important to check when setting up a reinvestment program – more on this in a future blog).  Once set up, there is very little work for the investor to do other than monitoring the investment.

The Case Against Automatic Dividend Reinvestment

Like anything that is set on autopilot, automatic dividend reinvestment takes discretion out of the investment process.  While this can have some benefits like continuing to invest automatically when stocks are down, it can also result in some unintended consequences.  One consequence is that it removes price from the equation – with automatic reinvestment, you end up buying at whatever the price is on the day the dividend is paid.  This can mean potentially buying a stock right after a large run up.  In addition, if you hold a portfolio of dividend payers, as many dividend growth investors do, then this process can result in buying a disproportionate amount of the higher yielding stocks in the portfolio.

Is there a Way to Get the Best of Both Worlds? – I believe so

In many years of dividend growth investing, I have developed a strategy that strikes somewhere in the middle.  Within a portfolio of dividend stocks, I find it often pays to simply collect the dividends and let the proceeds build up.  With the collected dividends building up, one can wait for a more opportunistic time to redeploy them.  Perhaps the market has a big downdraft or maybe one of the stocks in the portfolio sells off and there is an opportunity to buy in at a lower price.  Many other possibilities exist too, such as using the dividends accumulated from the higher payout companies to fund further investment in lower payout companies with stronger growth prospects.  If enough dividends accumulate, they may even be used to fund the purchase of a new position in the portfolio, thereby diversifying the portfolio further.

This process of manual dividend reinvestment offers some obvious advantages but also some drawbacks.  Most notably, it requires more work and discipline (such as not spending the dividends before they are reinvested again!) than automatic reinvestment.  In addition, this approach requires one to watch how transaction fees work.  Some platforms charge no fee for automatic reinvestment but might charge fees for this manual approach, so investors considering this approach need to check on this.

Like many things in investing, there is no right answer that fits every case.  While I have found this manual approach works well for the dividend growth portfolios I manage at Ridgewood Investments, this is in the context of managing these portfolios full-time.  Individual investors with more limited time might find the automatic approach has more appeal.  Either way, the potential benefits of reinvesting dividends are clear, but like many things in investing, the best way to go about this requires some thinking.