Benefits of Reinvesting Dividends
By Micheal James
There are two issues involved in 'reinvesting dividends'. One is dividend and the other is investment.
What is dividend? A dividend is what you earn on your share. Usually a dividend is paid in cash, but sometimes the companies offer stock dividends. You are given shares of stock against the dividend you earn. While some companies issue dividends on yearly basis, in most cases the dividends are paid quarterly.
Though a one time dividend, whether quarterly or annual, may appear too insignificant to merit reinvestment, the economics of returns on reinvesting dividends over a long time makes a fascinating preposition. Here is an example:
Suppose you invested $ 5,000 in the stock of a company in the year 1976. If you opted for reinvesting your dividends, your total assets after the three decades might amount to $ 1.4 million. If, however, you did not opt for reinvestment of dividends on your investment of $5,000 your total earning might not probably exceed only $375,000. You would be making over one million less in your earnings because you chose not to reinvest your dividends.
What actually happens when you reinvest your dividends is that you allotted more shares of the stock, which in turn, allow you to compound the returns on your original dividends. Your shares earn more value when their prices go up. Moreover, you also make more money by earning extra dividends that have accrued by reinvesting them into the stock.
Another interesting feature of reinvesting your dividends is that as the prices of your stock fluctuate, you will be gaining more shares when they become low and, of course, fewer shares when the prices rise. In actual practice, therefore, you benefit from dollar cost averaging when you reinvest your dividends.
It must be noted that most companies that pay dividends have DRIP or dividend reinvestment plans. These plans provide for reinvesting your dividends automatically in more shares of the stock. In most cases you are offered free services in reinvestment plans. This feature is more interesting to small investors who like to save funds for an extended period of time.
Some companies offer stock at discount from their spot price in the market if the investors opt for reinvesting dividends. Discounts can range from as little as 1% to as much as 10%. When these discounts are calculated with no-commission fee, the cost of these shares for an investor comes considerably down as compared to when he had bought shares outside the dividend reinvesting plans.
In case your dividends in any term are not sufficient to buy the high value stock, there is provision to buy fractional shares. It is, therefore, important to consult your stock broker and be sure before you invest whether the company whose stock you wish to buy offer options for automatic reinvestment of dividends in buying its stock. If you do not get the right broker to advise you on these issues, you may have to pay commission to your broker every time you reinvest your dividends. This may substantially reduce your earnings as the commissions will eat up most part of your dividends.
Moreover you must also check with your stock broker and tax consultant and plan for taxes on the dividends. It must be noted that reinvestment of dividends works best only when you have a long term perspective as the compounding effect would take place only over a long period of time. If you are looking for short short-term investment, dividend reinvestment may not prove to be a viable option.
The other benefits of dividend reinvesting are:
Opting for dividend reinvesting is easy. It takes only a few minutes to fill up the details. Your dividends are automatically reinvested. Once you join the scheme, the process becomes totally automated and requires no monitoring. You can also opt for partial reinvestment of dividend. You can continue to receive cash for some shares while reinvesting the dividend on the remaining shares.
The company offering dividend reinvesting options also benefits from such schemes as it gets low cost access to the public capital. Moreover the company ensures that its investor base remains intact and does not withdraw the capital easily as the investors do not exit the company when the value of its stock goes down. Since not all companies offer the dividend reinvestment plans, your broker can help you to reinvest your dividends at no cost.