This should be an easy answer to an easy question. Reinvesting dividends allows for greater capital appreciation. That means more of your money will be at work each time a dividend is paid out. You may have to ask yourself a few questions though. Would you rather have the cash today or would you be willing to wait a few years for the possibility of greater principal?
What is Dividend Reinvestment?
When you purchase a dividend paying stock, you may receive your capital gain distribution in the form of cash or stock. Most dividends are paid in cash, hence the possibility of passive income. However, there are some distributions that are paid in stock, creating an automatic reinvestment. If you receive your distribution in cash you may want to put that money back to work by purchasing more shares. There is a pretty easy way to do this with a dividend reinvestment plan. Most brokers will offer this as an option for you to put your dividends right back to work. However, if your broker does not offer this, you can usually purchase your shares directly from the corporation and start a DRIP plan.
The Dividend Reinvestment Plan: DRIP
Drip, Drip, did you hear that? It’s the sound of your portfolio building steadily and slowly. A dividend reinvestment plan, or DRIP, is a plan offered by the corporation. It will allow you to reinvest your cash dividends and receive stock or fractional shares instead. Typically this is a commission free transaction. It can be done through the corporation but there are also brokers that offer dividend reinvestment as a commission free transaction as well. Reinvesting dividends is a good idea for a few reasons.
Reinvest Dividends to Dollar Cost Average
When you reinvest dividends you are dollar cost averaging your purchases. If you are not familiar with dollar cost averaging here is a simple example that might help explain it a little. You own a factory and you make umbrellas. The price of umbrellas parts is constantly changing but you have to purchase these parts to stay in business. One week you place an order for 10 parts at 10 dollars each. The next week the price has gone down and you place another order for 10 parts at 5 dollars each. The next week the price goes up and you place another order for 10 parts at 20 dollars each. You could try to time your purchases and stock up when the price is low and not buy anything when the price is high but you have no idea when the price will be lower than it is today so you just keep placing the same order each week for 10 parts. On average, over those three weeks, you paid an average of $11.67 for each part. This same concept works for the stock market. When you reinvest your dividends you are buying constantly; when the price is high and when the price is low. This method of purchasing, dollar-cost averaging, is recommended by many as a way to ensure steady returns. A dividend reinvestment plan will allow you to do this.
Reinvesting Dividends Provides for Better Yields
Because you are continuing to reinvest your distributions, you are building a larger and larger growing base that you will continue to be paid on. If you started with 10 shares, you will eventually have 11 shares. A dividend of 10 cents for every share continues to build on itself. The first time you earned a dollar for your ten shares, but this time you will earn 1.10. As those bits of cash are reinvested you will see a higher and higher yield, very much in the way that interest compounds when you reinvest the interest payment.
With that in mind, do you like to reinvest dividends?
This is a staff post from LaTisha who writes about investing for beginners, saving and money management for the young adult or recent college grad at Financial Success for Young Adults. Visit YoungAdultFinances.com to see more from her.