Saturday, June 23, 2012

5 Keys to Reinvesting Dividends

Once you've decided to build a dividend-based portfolio, it's essential to know what you're going to do with the income generated by your investments. There are three basic options  -- spend the dividend, save it, or reinvest it. Sounds simple, but it's important to establish a strategy for your incoming dividends and make the most of those valuable cash flows.

The spending and saving options are fairly straightforward and are primarily used by investors looking to harvest the income from their portfolios to either support their lifestyles or to build up larger cash savings.

Reinvesting, on the other hand, is primarily used by investors with a longer time horizon and those who don't need the income now. There are two primary reinvesting methods -- automatic and the what I'll call the manual method.

With automatic reinvestment, you instruct your broker to take any dividend received and buy more shares of the same stock that paid you the dividend. Under the manual strategy, you instruct your broker to put all of your dividends into your cash account and when you've saved up enough, you make a larger investment in your favorite idea at the time.

There are positives and negatives to both strategies, but before you decide which one you'll use, here are five things to consider.

1. Costs

Jack Bogle, the brilliant founder of Vanguard, is famous for his mantra: "Costs matter." The more you pay your broker, the less you keep for yourself and the less money you have available to produce more income. Over time those costs and the lost compounding interest add up, so it's absolutely critical to keep trading costs as low as possible. For each trade you make, a good rule is to keep costs below 1.5% (i.e. if you pay a $10 commission, invest at least $667 at a time), but ideally much lower.

Check with your broker to see what type of fees might be associated with their dividend reinvestment scheme. Most US brokers don't charge for automatic reinvesting, but some brokers (particularly overseas, in my experience) may charge a fee for automatically reinvesting your dividends.

The size of your portfolio may help decide which option to use. For example, if you have a $20,000 portfolio with a starting yield of 4%, you would expect to generate about $800 in dividends in year one. If your broker charges a $10 trading commission then you'd be able to manually reinvest your dividends once per year and still keep trading commissions below 1.5% ($10/$800 = 1.25%). However, if your broker charges a 1% automatic reinvestment fee you might be better off with that option and keep your cash invested in the market (see key #2) versus sitting in cash earning no interest for the better part of  a year.

On the other hand, if you have a $100,000 portfolio with a starting yield of 4% and are generating $4,000 a year in dividends, you'd be able to make up to 5 fresh investments of $800 each year and keep costs below 1.5%. Your dividends might only be sitting in cash for a few months and you can be more active with your manual dividend reinvestments. 

It's important to note that if you have a small portfolio and are regularly adding fresh cash to it, you can consider lumping in dividend cash with fresh cash to make manual reinvestments. This would reduce the "waiting cost" for your cash not earning any interest.

2. Valuation

One of the benefits of manual reinvesting is that it gives you the opportunity to collect your cash and allocate it toward the most undervalued stock(s) in your portfolio. With automatic reinvestment, on the other hand, the cash is reinvested in the stock that paid the dividend without regard to timing.

In my mind, this does not necessarily manual investing a clear winner. I'll expand on this notion in key #4 below, but sticking with valuation for a moment, as long as you are reinvesting in what you consider to be undervalued stocks then either strategy can be beneficial.

If you're keeping a good watchlist that includes updated fair value estimates for your stocks, you'll have a better idea if and when your stocks become overvalued. If you're set up to automatically reinvest in an overvalued stock you can instruct your broker simply to not automatically reinvest that period. Instead, lump in the next dividend you receive from that stock with fresh cash added to the portfolio and invest it elsewhere. Once the stock becomes undervalued again, you can instruct your broker to automatically reinvest in that stock again. 

3. Be mindful of your broker's rules

Of course, the above strategy assumes your broker will allow you to choose a dividend reinvestment strategy on a stock by stock basis. My broker allows this, but others might not. 

In addition, most brokers in the US will allow you to reinvest in less than one share, but some brokers may not. For example, if the stock trades for $50 per share and the dividend received is $25, some brokers will not allow you to buy 1/2 a share. If this will happen frequently in your portfolio, you may want to consider manual reinvestments and lump in dividends received with fresh cash added to the portfolio.

If your current broker's dividend reinvestment options are limited, see if another brokerage firm has more flexible reinvestment options. As long as the other broker's costs and services are similar, it might be time to switch brokers.

4. Know yourself

This is perhaps the most important key of them all. Whichever strategy you decide upon, it's important to take into account your level of investing skill and discipline.

For instance, how good are you at determining a company's fair value? One of the benefits of automatic reinvesting is that while you may in hindsight have reinvested at overvalued prices you'll also have likely reinvested at undervalued prices and ultimately reinvested at fairly good prices on average. So if you're not keen on running discounted cash flow models or constantly comparing multiples, automatic reinvesting (all else equal) may be the better option as you'll invest a little in all of your stocks over time and reduce your risk of misallocating funds.

Conversely, if you choose manual reinvesting and don't have a good sense for valuation, you may end up allocating your cash to the wrong stocks at the wrong time. This can weigh on long-term returns. On the other hand, if you are a skilled investor you can greatly improve your long-term returns by allocating the incoming cash to the best opportunities.

Another question to ask yourself is: How disciplined am I? Manual reinvesting requires you to pay at least a moderate amount of attention to your portfolio and requires good record keeping (see #5); however, an investor who chooses automatic reinvesting could conceivably walk away from their portfolio for years (something I don't recommend) and will have had their dividends reinvested.

Automatic reinvestment is akin to dollar-cost-averaging -- a strategy in which the investor invests a little money at a time on a regular basis into the same stock regardless of current market price. Indeed, dollar cost averaging is a strategy Benjamin Graham (somewhat) advocated in 1962: "Such a policy will pay off ultimately, regardless of when it is begun, provided that it is adhered to conscientiously and courageously under all intervening conditions." 

By setting up automatic reinvestment, your dividends can be put to work without requiring you to make an explicit buy or sell decision. Trouble is we're often derailed from such a strategy by emotions (i.e. stop investing when the market falls, etc.) and lack of discipline. Even if you choose automatic reinvestment, a level of discipline is required though it's more of a passive hands-off discipline. 

Be honest with yourself. If you don't have the time, discipline, or skill required for manual reinvesting it's probably best to stick with automatic reinvesting -- again assuming all else is equal (costs, broker rules, etc.).

5. Keep good records.

Over time, all those little dividend payments and reinvestments add up and can become a bookkeeping nightmare. Whichever reinvestment method you choose, it's essential to keep good and updated records -- for both investing and tax matters. Keep and maintain a spreadsheet that tracks the income you receive from each stock as well as the prices paid for the stocks you bought via reinvestment. Every so often review your strategy and performance.

Bottom line

There's no perfect reinvesting strategy for all investors. Instead, consider which one is right for you given these five factors and go forth confidently.


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