Should You Reinvest Dividends?

When you buy a stock, mutual fund, or ETF, you are often asked whether you want to reinvest your dividends. This may seem trivial to you, but it could have a big impact on your investments, depending on how frequently dividends are issued and how large they are in comparison to the share price. To understand your options, you first need to understand what dividends are and how reinvesting them may or may not be beneficial.

What is a dividend?

A dividend is cash, or more rarely additional stock, distributed to shareholders from a company’s earnings. To be eligible to receive a dividend, you must own the security prior to an announced ex-dividend date and hold it through the record date, which occurs one business day after the ex-dividend date. Dividends are distributed on a per share basis, so the more shares you own, the more money you will receive. Dividends are considered a reward for investors, meant to maintain loyalty and increase trust in the company, among other reasons. While issuing dividends does result in a decrease in share price, since this is money flowing out of the company, this is generally not noticeable when combined with daily price fluctuations.

What is dividend reinvestment?

Dividend reinvestment, as the name implies, is when cash dividends you receive are reinvested in the same security at the time the dividends are distributed. This allows you to increase your holdings in a security, usually without paying brokerage fees. Since dividends received do not generally divide evenly into share price, you will often end up with fractional shares.

Is dividend reinvestment worthwhile?

There are a number of pros and cons to dividend reinvestment. In some situations, it can help you earn more from your investment, but in others, it may cost you money. The following are several scenarios to illustrate how dividend reinvestment can affect your returns depending on the performance of the security.

Scenario 1: Your investment increases steadily for years

Consider the case of Microsoft (MSFT), whose share price has been increasing relatively steadily for years while providing quarterly dividends.

Microsoft’s stock performance from 2016-2020. Dividends are indicated by “D” in a grey box.

If you were to buy Microsoft at the beginning of 2016 ($54.32) and sell it at the end of 2020 ($222.42), this is how your return would look (excluding taxes and fees) depending on whether you reinvested dividends:

Without dividend reinvestmentWith dividend reinvestmentDifference
Total return326%349%23%
Annualized return65.1%69.7%4.6%
5-year total return and annualized return for Microsoft with and without dividend reinvestment

As you can see, by taking advantage of dividend reinvestment, you would have increased your total return by 23%, or 4.6% per year. This is because you would have continued to buy shares in the company each time dividends were issued, and these additional shares would continue to grow as well. Keep in mind that the more shares you have due to your dividend reinvestments, the more dividends you receive the next time. This helps your investment to compound.

Scenario 2: Your investment decreases after purchase but rises back to the purchase price

Now let’s take a look at Lockheed Martin (LMT), which dipped in 2018 to a low in December of that year before finally rising back to previous levels.

Lockheed Martin’s stock performance from 2018-2019. Dividends are indicated by “D” in a grey box.

If you had bought Lockheed Martin at the peak before the dip ($361.00) and sold it a year and a half later when the price returned to just above the level you purchased it at ($373.49), this is how your return would look depending on whether you reinvested dividends:

Without dividend reinvestmentWith dividend reinvestmentDifference
Total return6.4%7.0%0.6%
Annualized return4.3%4.7%0.4%
1.5-year total return and annualized return for LMT with and without dividend reinvestment

The overall return in this case is not very large, which is unsurprising since the stock price barely increased. Without dividends factored in, the total return would have been just 3.5%. You can see the power of dividends here as the actual return is about double that whether or not they were reinvested. But by reinvesting dividends, the annualized return would increase by an additional 0.4%. This is because the dividends were reinvested while the stock price was below the purchase price, essentially allowing you to average down your effective purchase price. I realize that 0.4% per year may not seem like much, but it adds up, especially as this money continues to compound over time. The difference would also be larger for a company that issues larger dividends compared to its stock price.

Scenario 3: Your investment increases for a time but then returns to your purchase price

Now let’s turn to examples where reinvesting dividends actually backfires. Consider New Residential Investment Corp. (NRZ), which is a Real Estate Investment Trust (REIT) and thus issues above average dividends. The current dividend yield of NRZ is 7.61% per year, according to Yahoo! Finance. NRZ’s stock price increased over the past five years before crashing in 2020. Since then, it has begun to recover but is still far below its peak.

NRZ stock performance from 2016-2021. Dividends are indicated by “D” in a grey box.

If you had purchased NRZ in January of 2016 at $10.60 per share and sold it 5 years later at the beginning of 2021 at $10.28 per share, your return would be as follows depending on whether you reinvested your dividends:

Without dividend reinvestmentWith dividend reinvestmentDifference
Total return75.5%69.5%-5.9%
Annualized return14.8%13.7%-1.2%
5.08-year total return and annualized return for NRZ with and without dividend reinvestment

Though in this scenario you’d be selling at a lower price than you purchased the stock, you’d actually end up ahead about 70% total (or 14% per year) due to dividends, which is pretty incredible! However, if you reinvested your dividends, you’d end up with about 6% less (or 1.2% less per year) than if you kept the dividends as cash. This is because most of the dividends were issued when the stock price was higher than your purchase price, effectively averaging up your purchase price. That said, dividend reinvestment would come out ahead if the stock rose about one more dollar to $11.13 (not including future dividends). This is why holding through a downturn is usually a good strategy.

4. Your investment decreases steadily for years

Finally, let’s consider Macy’s (M), whose stock has been decreasing for years.

Macy’s stock performance from 2016-2021. Dividends are indicated by “D” in a grey box.

If you were to buy Macy’s stock in the beginning of 2016 and sell at the beginning of 2021, this is how your return would look depending on whether you reinvested dividends:

Without dividend reinvestmentWith dividend reinvestmentDifference
Total return-48.7%-57.0%-8.2%
Annualized return-9.7%-11.4%-1.6%
5-year total return and annualized return for Macy’s with and without dividend reinvestment

Clearly, anyone who invested in Macy’s years ago would be losing money now. Even though it’s commonly advised to buy and hold for the long-term, keep in mind that this is advice for the market as a whole rather than for individual stocks. Sometimes you have to cut your losses on an underperforming stock. In this case, dividends were not enough to save stock performance. In fact, dividend reinvestment just exacerbated the problem. By reinvesting dividends, losses increased by 8.2% overall (or 1.6% per year). This is because, even though you were averaging down, the stock price just kept falling. Unless the stock eventually turns around, you wouldn’t be able to salvage your losses by reinvesting the dividends.

Summary

As you can see, dividend reinvestment can be either good or bad depending on how the market (or individual stocks, mutual funds, or ETFs) perform. Here is a summary of the pros and cons:

ProsCons
Keeps your money in the marketIf a stock is performing poorly, reinvesting will sink more of your money into it
Allows you to dollar-cost averageYou don’t have control over when the money is reinvested
The more shares you have, the more dividends you will receiveYou may reinvest when the stock is at a temporary high point
When stock prices dip, you can average down
If the stock is doing well, you can take advantage of continued growth
Pros and cons of dividend reinvestment

There are obviously cases where reinvesting dividends ends up losing you money, but generally, reinvesting dividends is the better choice. If you are confident that your investments will grow in the long-term, then reinvesting dividends will help your money continue to compound. It will allow you to buy more shares, thus increasing your future dividends, and it will keep your money in the market instead of idling as cash in your account.

4 thoughts on “Should You Reinvest Dividends?

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s