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The Best Way To Reinvest Your Dividends For Retirement

The Best Way To Reinvest Your Dividends For Retirement by Chuck Carnevale, F.A.S.T. Graphs

Introduction

Reinvesting your dividends received from high-quality dividend growth stocks is a great, relatively conservative and proven way to build wealth over the long term.  This is especially true and appropriate for investors in the accumulation phase that are planning for future retirement.  Accumulating additional shares of dividend growth stocks can, and will, provide an increasing and eventually larger stream of income available at retirement when income is needed most.

There are two primary strategies that can be implemented to reinvest the dividends provided from a portfolio of dividend growth stocks. First of all, most high-quality dividend growth stocks investors have the option of enrolling in formal company dividend reinvestment programs, also known as DRIP plans.

When the investor formally enrolls in a dividend reinvestment plan, they will no longer directly receive their dividends in cash.  Instead, the dividends will be automatically used to purchase additional shares of stock in the company.  Also, if the company you own does not have a formal DRIP plan, many brokerage houses offer their own plans that will allow you to reinvest your dividends directly back into the company.

The second strategy for investors interested in investing their dividends is informally known as “collect and invest.”  With this strategy, the investor allows their dividends to accumulate and then personally picks and chooses which companies they will add this fresh and received dividend capital to.  The central idea behind this strategy is to avoid reinvesting dividends into high-priced or overvalued stocks and opting instead to reinvest accumulated dividends only into low-priced or undervalued stocks.

Which strategy is the best way to reinvest dividends?

One of the most commonly asked questions I receive from dividend growth investors is which or what is the best way to reinvest their dividends.  The following is a classic example of this question that I was recently asked:

“Reinvesting Dividends?  Currently for both my taxable and IRA accounts I reinvest all my dividends automatically back into those companies every quarter. Is this the best approach or should I reinvest these funds in stocks that are currently “fair valued” every quarter?”

In my personal opinion, both strategies are viable and attractive. Moreover, there are advantages and disadvantages to both. Automatically reinvesting dividends each quarter takes advantage of the underlying and proven principal of dollar cost averaging – but with a slight twist.  I will elaborate more on the twist I’m referring to later in the article.  The primary benefit of this principle is that it takes all decision-making, thought and emotion out of the equation.

If the price of the stock you are automatically reinvesting in is high (overvalued or expensive), your dividends automatically buy fewer shares. If the price of the stock you are automatically reinvesting in is low (undervalued or cheap), your dividends automatically buy more shares. Consequently, your money is in essence being more aggressive when prices are low and more conservative when they are high. In the long run, your average price will balance or average itself out. I am a big believer in dollar cost averaging; in over my almost 50 years in finance, I have seen it work quite well many times.

On the other hand, collecting dividends each quarter and then reinvesting them only in stocks that you feel are currently fairly valued is also a great strategy. In theory, you would be more likely to be making sound and more profitable investments with each dollar available. However, both judgment and time are required.

In other words, collecting dividends and then allocating them only to the stocks you feel are appropriate is both more research-intensive and time-consuming.  Furthermore, both judgment and emotion are involved. Personally, this is the approach that I prefer and utilize. However, I am a professional that analyzes investments all day – every day. Therefore, I have the time, experience, and with all due humility, the knowledge to most effectively reinvest the dividends I gather into what I consider the best valued choices available at the time.

Consequently, I do not think either option is right or wrong.  Moreover, I do not consider either option necessarily better or worse than the other.  The best choice ultimately comes down to the one that each individual investor is most comfortable with and capable of executing. In the long run, I have seen both approaches succeed.

The Difference Between Dollar Cost Averaging And DRIP Investing (Dividend Reinvestment Plans)

DRIP investing plans, in essence, take advantage of the concept or principal of dollar cost averaging.  However, there is a subtle difference based on the purest definition of dollar cost averaging.  In its purest form, dollar cost averaging is mostly about applying a disciplined investment strategy.  The discipline comes from investing a specific or equal amount of money over specific and consistent timeframes.  For example, an investor might commit to investing $100, or $500, or $1000 each and every month for years.  Here is the precise definition of ‘DollarCost Averaging ((DCA)) courtesy of Investopedia:

“The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high.”

A DRIP plan (dividend reinvestment plan) works in the same disciplined fashion as dollar cost averaging, and therefore, offers similar benefits.  However, there is a primary difference, but it is subtle in nature.  When you are automatically reinvesting your dividends, the amount of money you are investing each quarter is not necessarily fixed.

If you are investing in Dividend Champions or Aristocrats, for example, your dividends are, in theory, increasing each year.  Therefore, the total amount of money you are automatically reinvesting each year changes.  You are still applying the discipline of investing on a regular schedule (quarterly), but the total amount of money you are investing varies each year.  Nevertheless, you are still applying and receiving the benefit of buying more shares of stock when prices are low, and fewer shares when prices are high.  Consequently, the averaging out aspect still applies.  Here is the precise definition of a Dividend Reinvestment Plan courtesy of Investopedia:

“ DRIP‘ A plan offered by a corporation that allows investors to reinvest their cash dividends by purchasing additional shares or fractional shares on the dividend payment date.”

Reviewing the Theoretical Advantages and Disadvantages of DRIP versus Collect and Invest

I have already thoroughly covered the advantages of applying an automatic dividend reinvestment plan (DRIP).  Nevertheless, the primary advantage is worth repeating and elaborating on.  Every time an investor is required to make an investment decision, they are simultaneously placed in the position of making a potential mistake.

For example, a stock that they believe is undervalued based on current earnings, could be an illusion if future earnings collapse.  In other words, their judgment and analysis could be in error.  Furthermore, investors always face the innate emotional fight or flight response.  In other words, it’s often hard to invest in a stock after its price has fallen precipitously.  Even though it might be the right long-term decision, it’s often quite difficult to pull the trigger.

Consequently, the primary advantage of a DRIP program is that it takes advantage of the principle of dollar cost averaging, while simultaneously taking out the risk of