Dividend reinvesting can be a powerful compounding tool, but you might consider taking the income for other purposes.
If your investments pay dividends, you may be wondering whether you should take them as cash or reinvest them, which will give you more shares over time.
The answer depends in part on your investment goals. Some investors use dividends as a source of income to cover everyday expenses, while others focus on increasing their savings. For those who are focused on longer-term growth, dividend reinvestment can be a savvy way to multiply your gains, says Robert Siuty, senior financial consultant at TD Ameritrade.
Dividend reinvesting can be done automatically or on your own. Here are two ways you can reinvest your dividends:
In deciding whether to reinvest your dividends or take them as cash, consider what compounding can do. For example, take a $10,000 investment in a stock with a 3% annual dividend and apply some simple math (see figure 1). The first year, that investment could have risen to $10,300. If the company pays the same 3% annual dividend the next year, it could grow to $10,609. Repeat in year three, and the investment would be $10,927. Repeat for 10, 20, or 30 years, and compounding can dramatically enhance potential returns.
But this scenario doesn’t consider the value of the stock itself. If the stock price appreciates at the same time, say 5% annually, the total return would be 8%. By year three of our example, that 8% return on the stock would have grown the total investment to $12,597 and change.
But remember, this is a simplistic look. Dividends and dividend rates fluctuate, as do stock prices. Past performance is not a barometer for future results. The stock market doesn’t climb in one neat trajectory; it zigs and zags, sometimes dramatically. And companies cannot guarantee their dividend payouts. Profits rise and fall, business cycles happen, and the economy can be bumpy. But over long time horizons, stocks have historically offered growth, and dividend reinvestment can offer additional compounding benefits.
It depends on your goals and financial needs. There is no right or wrong answer here because the correct response is what best fits your own personal situation.
You can use a dividend reinvestment strategy to attempt to save more, grow more, and accumulate more savings. On the other hand, if you need to meet short-term goals or cover everyday expenses, you might want to take your dividends as cash.
“Taking the income in those situations might make sense,” Siuty says. “You’re still maintaining a position in the stock, while keeping the same amount of shares within the company and benefiting from potential capital appreciation.”
No matter what your approach to dividends, whether you choose to reinvest or take the dividends as cash, keep a close eye on the stock. Monitor the stock’s price regularly and stay informed of any changes to dividend payments so that you can make sure your strategy is working in your best interest.
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