Dividend Reinvestment

In an earlier post, I gave a short overview on the topic of dividend reinvestment; namely, by saying it’s something you should do as part of a long-term growth strategy.  In this post, I’ll talk about it in greater depth and offer some alternatives to re-investing in the same security as you pursue early retirement.  Dividend reinvestment is a critical aspect of retirement savings, but a topic that often doesn’t get much coverage, so here I’ll explain what dividends are and why reinvesting them while you’re saving for the future can make a major difference as you strive toward FIRE. 

Let’s start with the basics: dividends are one of the two primary ways that holding a share of stock can earn you money, the other being an increase in the value of the share itself and selling it at a gain. 

First, it’s important to understand that dividends are not a given for any stock in any given year.  A company’s board of directors must declare a dividend payment before shareholders are entitled to anything – dividends are not simply paid as a matter of course.

Historically, dividends were viewed as a way to distribute profits to the company’s owners – the shareholders.  After all, as a holder of a share of stock, you are technically a part owner of the company and should reap some of the financial benefit.  In recent years, as many things about stock investing have, the connection between annual profits and dividends has not been quite as correlated.  Boards now commonly withhold dividends to maintain a cash balance, and, on the flip side, there are times when shareholders will get a dividend payment even when the company is having a less than profitable year.  

Companies may issue dividends even in a down year if they pay dividends from cash reserves rather than annual profits, and some companies may not want to be seen reducing dividends in an unprofitable year lest the losses seem worse than they are.  As stock prices have become a proxy for a company’s health (valid or not), boards are often hesitant to take measures that spook analysts, even if that means using cash on hand to pay dividends.  There are other reasons companies may pay dividends in down years too, such as when the company still has positive cash flow but records a net loss – say due to a paper-only loss.  I won’t get into the details here. 

When researching stocks, it’s often fairly easy to locate how often a company has historically paid dividends and how much.  The amount of a dividend is paid on a per share basis, so you’ll see, for example, that a company paid $0.50 per share, and can calculate how much you’d receive based on that information if the company continues to pay dividends in roughly that amount in the future.  

Remember too that for publicly traded companies with multiple classes of stock, the different classes may receive different dividends, and some of the share classes might not receive dividends at all.  So make sure you’re buying the right share class if you’re looking for dividends.

A few other critical factors on dividends.  When paid, dividends are paid on a specific date.  However, other dates to keep in mind are the ex-date (or ex-dividend date) and the record date.  The record date is the day when the company identifies who all the current shareholders are that will receive the dividend, and the ex-date, which is before the record date, is the date by which your shares must be purchased before you can be a record shareholder on the record date.  So once a dividend is announced, you have to complete the purchase of any shares on or before the ex-date to receive the payment.

This is important because there can be a lag-time between the record date and the payment of the dividend.  If what you’re after is the dividend payment, be careful not to purchase shares after the ex-date because you won’t receive the payment even if you hold shares on the day the dividend itself is paid.  Or, more accurately, you won’t be entitled to the immediate dividend payment – you’ll have to hold on to the share until the following ex-date for the next dividend, which could be months or more later.

Over time, if you look for market trends, you’ll see that stock prices tend to rise when a dividend is declared, as people buy the stock before the ex-date to claim the dividend.  Then, once the dividend is paid, the stock price falls because investors are no longer interested in holding it and the company has less cash on hand.  This trend does not always hold due to the millions of other reasons why stock prices are all over the place.  Just be aware of this if purchasing a share of stock after a recent ex-date – you might be buying a share that’s temporarily inflated due to an upcoming dividend for which you won’t be eligible.

Reinvesting Dividends

So you’ve found a company that pays dividends and you’ve bought shares in the stock – now what?  Eventually the company will pay that dividend and you’ll receive cash.  If you hold the stock in a brokerage account, that cash will show up in your account balance.  You might not even notice it if you don’t have automatic notifications set up or if you don’t check your positions six to ten times a day (now who would do that?).  If you hold the stock directly through the company’s share administrator, you’ll probably get a check or have the funds direct-deposited depending on what you’ve set up.

Now we get to the point – what do you do with that cash?  And the simple answer for the long-term FIRE / retirement investor is to re-invest it! 

Simply put, dividend reinvestment is using the cash received from a dividend payment to purchase more shares of the same stock.  And with the ability to purchase partial shares available through most brokerages nowadays, you can do a direct swap: whatever you get, just use it to buy as much of the stock as you can.  Some brokerage accounts make this easy for you by allowing you to set up a process to reinvest dividends in the same shares automatically each time you receive a cash dividend.  This option is the best because it removes the guesswork and the human error (i.e., you forget) factor.

You can also reinvest dividends manually by monitoring when you receive them and immediately purchasing shares when the funds become available.  And of course, there’s nothing that says you have to repurchase the same stock with the dividend payment.  Theoretically, purchasing the same equity with the dividend payment allows you to take advantage of the recently decreased price, but as the link between share price and dividends has become less certain, following this old pattern is no longer as critical.  You could use the dividend payments to purchase new shares in something else and further diversify your holdings.

The point of dividend reinvestment is to keep your money invested – letting it ride, so to speak – rather than withdrawing it and diminishing the value of your account at a time when you’re striving for growth.  In fact, the 6% annual rate of return I use to calculate future returns assumes that dividends are being reinvested.

The approach to dividends may change later when you’re living off investment returns and dividends become a critical portion of your income.  Your approach may also differ if you do actually need the cash from dividends even while you’re still saving, such as to pay the taxes you incur on your investments – including the very dividend you received.  If you need a refresher on dividend taxation, you might want to re-read this post: Investing – Common Tax Issues. 

Other Cash Received

Let’s shift from stock-related dividends for a second and talk about some other cash infusions you might receive, and which you should consider reinvesting rather than withdrawing; specially, bond income.  If you hold bonds in your portfolio, you may receive cash from interest payments or when the bonds mature. 

Like with stock dividends, while you’re in the investing and savings portion of your life, the best course of action may be to reinvest that cash immediately rather than withdraw it so that you can continue to keep your long-term growth on track.  With money from bonds, you’ll have to do this manually, and you’ll have to select the asset you want to purchase, so treat the cash received from interest and maturity payments the way you would any cash you deposit into your brokerage account and choose your investments wisely.

Alternative Dividends

Finally, before we leave, one last concept about dividends and dividend reinvestment.  Not all dividends from equities are paid in cash, though cash dividends are by far the most common.  But you may also see equities that distribute dividend payments in the form of stock or other property. 

I won’t get into the details of these here because they’re not relevant to dividend reinvestment – I mention them only for the purpose of addressing their existence.  If you purchase an equity that pays dividends in a form other than cash, you’ll have to consider what to do when you receive the distribution, as well as properly determine the tax treatment.  Like everything I talk about: just don’t let yourself get caught unaware.