When it comes to dividend investing, one of the big questions investors must answer for themselves is what to do with the dividend income they receive. There are really 4 things an investor can do with his dividend income.
Use the dividend income to cover expenses and spend on whatever the investor pleases.
Use the dividend income to purchase other types of investments such as bonds or real estate, etc.
Reinvest the dividends back into the company which paid them.
Collect the dividend income and choose a different company for dividend reinvestment.
Most likely, if you are financially independent and living off the dividends, then you will follow the first option and use your dividend income to cover your financial obligations.
If you are still in the accumulation phase, building your portfolio towards your ultimate goal of financial independence, then I would recommend reinvesting the dividend income. This allows the dividends to have a compounding effect on your wealth. You will purchase new shares with your dividend income and those new shares will begin paying you dividends. Of which you can use to collect even more shares.
There are two ways to reinvest your dividend income. You can either use the dividend income to buy shares of the same company that paid the dividend, or you can decide to use the dividends to buy shares of a different company.
Both methods work well and each has their own pros and cons worth considering.
Reinvesting in the Same Company
Many investors like to use their dividend income to purchase shares in the same company that paid out the income.
You can do this by manually going out and making a new buy transaction with the dividend income received. However, this is fairly tedious and there is a better way.
Investors wanting to reinvest back into the same company should consider what is called a DRIP (dividend reinvestment program). There are some brokerages that allow free or fee based DRIP’s. Also, there are many companies that offer their own DRIP programs. These involve signing up through the company. Investors should be aware that different programs have differing fee structures (some reasonable while others not worth the high cost).
Pros of Reinvesting Back Into the Same Company
Simple – Investors make it automatic and don’t have to decide which company is best to purchase.
Great companies – Investors already know they want to own that particular company and therefore are just adding to thier already established position.
Sometimes low fees – There are some brokerages or companies that offer very reasonable reinvestment fees. Oftentimes these fees are lower than the normal brokerage fees for a regular buy.
Cons of Reinvesting Back Into the Same Company
Valuation – Investors are buying shares in a company regardless of valuation. Sometimes stocks are overvalued and there are probably better opportunities for your money to be invested elsewhere.
Sometimes high fees – While some brokerages and companies offer low fee reinvestments, others sometimes are fairly high. Investors should make sure they understand all fees involved before reinvesting. It is important to keep fees down below at least 2% of transactions so as not losing all your money to the brokerage houses.
Not available through all brokers – Not all brokers give investors the ability to automatically DRIP their dividends. I personally use Scottrade and they currently don’t offer this option.
Reinvesting in a Different Company
Another option for reinvesting dividends is by collecting all your dividend income payments and then using the money to purchase shares in a company of your choosing. This could be the same company that paid out the dividend income or it could be a completely different company.
This is the strategy I personally use. I have a fairly small portfolio right now so I collect the dividend income and add new investment capital to make new purchases. I do this for many reasons listed in the pros below.
Pros of Reinvesting in a Different Company
Valuation – The main reason I prefer this method is it allows me total control over which company stock I am now purchasing. I can look over valuations and decide on the best valued stock opportunity I want to purchase at any given time. I am not automatically purchasing new shares in a company that I believe to be currently overvalued.
Low fees – I make sure to combine my dividend income with new capital to keep my brokerage transaction fees low. New purchases fees are my normal commissions I pay for any buy. I make sure to keep these fees always below at least 2%.
Method can be used through any broker. While my broker doesn’t allow a DRIP, I am able to reinvest dividends with this method.
Cons of Reinvesting in a Different Company
Not Simple – With each purchase I have to make a decision about what company I want to currently buy. I have to research different companies and valuations to decide upon the best opportunity.
Cash not put immediately to work – I have to wait until either my dividend income is high enough for a purchase or until I have enough new capital to contribute before I can put that money to work with a new purchase. This means sometimes I will have a few hundred or so in cash. That cash will not be earning me more dividend income yet. It will not be put to use until I have enough cash to make a big enough purchase to keep my transaction costs low.
If you are in the accumulation phase of investing then it is a good idea to reinvest your dividends. Either method works fine and you have to decide for yourself which you prefer.
I like to have control over what I am investing in and I like to try and pick the best valued opportunities available. Investing in dividend growth stocks is a fun hobby for me and I enjoy researching different companies. For all investors this isn’t exactly the case. Some investors may want to make things easy by automatically reinvesting in the same company which paid out the income.
The choice is yours. Either way you choose, make sure you reinvest your dividend income so you are not losing out on the power of compounding dividends!
What do you do with your dividend income? Do you reinvest? If so what strategy do you use to put that dividend income back to work?