You’ve probably heard many times that you should always reinvest dividends, but you may have also heard reasons not to always automatically reinvest dividends. Ultimately, you should make the right choice for your own investing, which includes understanding the pros and cons. There are two reasons we don’t reinvest dividends that you might consider when reviewing your own situation.
Start by understanding what dividends mean
You typically have the opportunity to make money in stocks in two ways. The first is through capital appreciation. You experience capital appreciation when a stock is worth more than you originally purchased it for, just like when your home goes up in value. The second way to make money is to buy a dividend-paying stock that gives distributions of a company’s earnings to shareholders. This distribution is generally paid on a quarterly basis, is subject the approval by the board of directors of the company, can increase or decrease at the company’s discretion, and is not guaranteed. You can also think about making money in stocks like buying rental property. If you eventually sell the building for more than you paid for it, you have capital appreciation, but in the meantime you should receive rental income from your tenants (dividends). You just hope you have reliable tenants so that your “dividends” are paid regularly!
You’ve probably heard the old adage “buy low, sell high” which effectively explains how to optimally win with capital appreciation in the stock market. But that is easier said than done. Dividends can sometimes be a more reliable option. Regular cash flow from dividends can boost returns substantially over time. In fact, dividends contributed to a significant portion of returns on the S&P 500. Ideally, as the likelihood of making money in stocks goes up substantially over longer holding periods, so does the contribution rate of dividends to total return. It is no surprise that a diversified portfolio of dividend-paying stocks held long-term has historically been a winning combination.
Dividend reinvestment or not? Which is right for you?
You now have a choice of what to do with those dividends. Do you simply take them in cash, or reinvest them back in to the same stock that paid the dividend? If you believe that a stock is attractive you may choose to reinvest the dividend into the same stock automatically. Dividend reinvestment is attractive when the company appreciates over time, and the dividend is steady — or even better, increasing. In that case you experience a snowball effect with your investment. Sounds great, right? It is a powerful way to build wealth, but not without caveats. A potential drawback is when your investment is only in one or a few companies and you end up with a concentrated portfolio in a limited number of stocks. In other words, you lessen your diversification. You’ve probably noticed that we sneak “diversified” into most things we write. We love diversification because it is one of the main determinants of success in growing wealth over the long-term.
But don’t forget, you do have another option. You can use the dividends to fund future purchases of different stocks you don’t currently hold, which can be an effective way to diversify your portfolio. Simply let the dividend distributions accumulate in your brokerage account; then use the cash to buy stocks of other companies. As you expand your basket of dividend-paying stocks, the funds will ideally accumulate faster. (Again, the snowball effect!) Many money managers, including AFAM Capital, prefer this method. The disadvantages? There is no guarantee that the new stocks you purchase with your dividend proceeds will do better than the original stock that produced the dividend. There are also no guarantees that dividends will continue to be paid, or that they will continued to be paid in the same amounts.
A second reason we don’t reinvest dividends
The first reason AFAM Capital doesn’t reinvest dividends is so we can diversify. But there is another reason as well. We are relentless bargain hunters, always looking for a better deal.
The first step in our bargain hunting process is the use of our value-scoring algorithm, which uses more than a half-million data points each day in the fundamental framework.
Next, our investment committee applies a human review to the prospects generated by the algorithm. The committee reviews financial strength and potential earnings in addition to higher-level qualitative aspects to clarify potential risks and rewards.
Finally, we pool dividend payouts as well as other funds and invest in the new prospects generated by our computer-human review process. Our goal is always to find better performers. Like most investors, we do not always pick winners, which ties back into why we diversify.
Should you reinvest dividends or not? Make the best choice for you
So, next time you ask yourself if you should reinvest dividends, start by understanding the pros and cons of each. You can exclusively reinvest dividends. Or don’t. Or do both. Work with a trusted financial professional to determine the right path for your situation.
Nothing presented herein is, or is intended to constitute, investment advice, nor sales material, and no investment decision should be made based on any information provided herein. Information provided reflects AFAM Capital, Inc.’s (AFAM’s) views as of a particular time. Such views are subject to change at any point and AFAM shall not be obligated to provide notice of any change. While AFAM has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability or completeness of third party information presented herein.
No guarantee of investment performance is being provided and no inference to the contrary should be made. There is a risk of loss from an investment in securities, and payment of dividends cannot be guaranteed. Past performance is not a guarantee of future performance.
AFAM Capital, Inc. is a Registered Investment Advisor. Al Frank Asset Management and Innealta Capital are divisions of AFAM Capital. AFAM is editor of The Prudent Speculator newsletter and is the investment advisor to individually managed client accounts and certain mutual funds. Investing involves risk, principal loss is possible, and there can be no assurance that investment objectives will be achieved. Past performance is no guarantee of future results. Registration of an investment adviser does not imply any certain level of skill or training. 12117 FM 2244 | Building 3, Suite 170 | Austin, Texas 78738 | p: 512.354.7041 | f: 512.597.2500 | www.afamcapital.com | 050-AFAM-1/31/2017
 Since 1927. SOURCE: Al Frank using data from Professors Eugene F. Fama and Kenneth R. French