Is Reinvesting Dividends A Smart Strategy?

Dividend stocks are an essential part of many investor portfolios. Dividends are a way for companies to attract people to invest in them, even though they may not have the forecasted growth or growth prospects that some of their peers enjoy.

When companies pay a dividend, they are essentially saying that they could not find an investment that would produce a higher return than that dividend yield. The Financial Samurai explains the concept of dividends by comparing Tesla [NASDAQ: TSLA] and AT&T [NYSE: T].

AT&T [NYSE: T] is a very mature company and it functions like a utility. It has steady cash flow and a large subscriber base, but it doesn’t have many opportunities for reinvestment, so it pays a 5% dividend yield.

In contrast, Tesla is all about research and development. It does not pay a dividend because it uses its extra earnings to fund those endeavors.

Using your Dividends

Different investors use their dividends in different ways. For some people, dividends are a source of passive income. They might use the dividends they receive to supplement their income or sustain them altogether.

The only problem with this strategy is that most dividend yields are very low. If your average dividend yield is 3%, you would need to have $2 million invested in those stocks to earn $60,000 a year.

You can also choose to reinvest your dividend payouts.

Understanding Dividend Reinvestment Plans

There are two ways to do this:

Brokerage Account: If you invest in stocks through a brokerage account, you will have the option to reinvest the amount of your dividends into other stocks or funds.

Dividend Reinvestment Plan (DRIP): You roll your dividends payments over into new stock purchases with the SAME company that pays you dividends.

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Dividend Reinvestment Plan Pros

Brokerage dividend reinvestment plans may be a good choice for investors who want to diversify their investments.

Some people simply do not want to expand their position in a particular company but would rather invest in other companies. In addition, brokerage accounts let you invest those dividends in any stock you want.

DRIP plans are offered on a company basis. You don’t have to have a brokerage account, and you can use your dividends to purchase partial stocks. For instance, if the per share price is $100 and your dividends are $30, you can still reinvest it in that company’s stock.

In some cases, Company DRIP plans sweeten the deal but offering existing shareholders discounts on those shares purchased through dividend reinvestment.

Moreover, company dividend reinvestment plans tend to have lower fees than most brokerages. Finally, you might also be able to enroll in a company DRIP via your IRA.

What are the Drawbacks of DRIPs?

The biggest downside with brokerage DRIPs is that you will be bound by the same restrictions you will face if you invested cash. You can’t buy a part of a stock, and there will likely be a brokerage fee for processing your request.

In some ways, company DRIPs might sound like a no-brainer, but there are several reasons why you might prefer a brokerage DRIP or taking the payout.

1. Time. The company paying you dividends will reinvest your payouts on their own timelines and may take their time when you ask to sell your shares. The difference of a few minutes, hours, or days in the company share price may be minimal, but not always.

2. Fees. There can be fees to join a company DRIP. You might also incur extra costs when you go to sell your shares. You could have a flat fee as well as a per-share charge (Example: $15 plus $0.12 per share).

3. Procedure. The more company DRIPs you have, the more paperwork you can expect.

How Warren Buffett Invests in Dividend Paying Companies

Warren Buffett is a big fan of dividend-paying stocks. According to Wyatt Research, “The top 10 holdings in Berkshire’s stock portfolio account for 80% of portfolio value. All are dividend-growth stocks” – and he has owned them for a long time.

The length of the investment is an important consideration because it gives long-term investors the ability to recoup their investment.

Buffett bought $1 billion of Coca-cola [NYSE: KO] stock in 1988. At that time, the share price was $2.50. Wyatt Investment Research estimates that Coke will be offered $2.50 in per-share dividends by the year 2026, meaning that Buffett’s initial investment will be covered completely.

All the money he has earned on this investment in dividends before and after that year would all be gravy, and that is in addition to the actual growth in share price.

The Power of Compounding

Dividends are powerful in the long run. While if you choose the right stock, the value of your investment will grow, dividends take it to the next level, especially in a company DRIP.

Every single cent you earn on your investment goes back into the company to increase your position and ultimately make even more on your investment.

Simply put, if you reinvest your dividends in the same company, you are going to earn exponentially more on your investment than if you had taken the payout every year because your position in the company will be larger every year.

Reinvesting your dividends can be a smart part of a long-term investment strategy because of the magic of compounding, but, again, only if you pick the right stock.

If you choose poorly and the share price declines over the years, the dividend will do nothing more than recoup your loss, so do your research first. Also, make sure you understand the downsides to whatever dividend reinvestment plan you choose.