The time-tested wisdom from leading value investors has always been that if you want to make money in the stock market, invest in high quality stocks and do not sell them in the short run, irrespective of the market fluctuations.
However, to maximize your returns on your long-term value investments in the stock market, you should also consider a dividend reinvestment strategy that consistently grows your portfolio over the long haul.
A sound dividend reinvestment strategy will turbo-charge your stock portfolio (or mutual fund investments) over time. The strategy works equally effectively for exchange traded funds (ETFs) too.
You can choose from different investing approaches to deploy your dividends. The right dividend reinvestment strategy will depend on your investment goals, time horizon, and your degree of risk tolerance.
Consider the following strategies, which will work whether your dividends are generated from stocks, mutual funds, or ETFs.
DRIPs or dividend reinvestment plans
The most simple and widely-accepted dividend reinvestment strategy is to create an automated dividend reinvestment plan. You could do it through your stock broker or directly with the issuing mutual fund or ETF firm.
This plan will ensure that all the dividends you earn are immediately deployed to buy additional stocks. This process will occur automatically without your involvement.
If you have a longer investment time horizon (say, at least five years) DRIPs could be your ideal strategy.
Some of the funds and DRIP plans will allow you to purchase only whole shares, while some others will permit fractional stock reinvestment. In the former plan, you might be required to occasionally buy a few shares in lieu of the fractional stocks.
DRIP strategy is viewed as a cost-averaging strategy because the plan will automatically buy more stocks when prices decline and fewer when they are rising.
If you are looking for a low-maintenance dividend reinvestment strategy, a DRIP could be the right choice. It enables your broker to automatically buy stocks on your behalf from your dividend payouts.
If you are prepared to hold your stocks for years, a DRIP strategy will encourage you to invest and save most effectively year after year.
Notable points about a DRIP
Although the DRIP strategy offers you numerous benefits, it is pertinent to note some key issues.
First, you should know that when you create a DRIP through your broker, they may charge a commission on every dividend reinvestment. On the other hand, if you are holding your stocks directly with a fund manager, they will usually provide the DRIP service for free.
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The second important thing to note about the DRIP strategy is that it does not give you any control over your buying price. There could be a situation where you feel that a particular stock in your portfolio is “overpriced” while another looks more undervalued.
Under a DRIP approach, the plan will still buy the “overpriced” stock at the prevailing price.
While dollar cost averaging forces work in your favor over time, once you enroll in a DRIP you will have to forgo some control over your investments.
Third, you should also remember that while your dividends will be immediately deployed to purchase more stocks, you will still have to pay the tax on those dividends. The IRS still counts those dividends as income.
Reinvesting at market lows
Some investors choose to follow the “timing the market” strategy for dividend reinvestments. They will ask their brokerage firm to continue to deposit their dividend receipts in their account.
As the money keeps accumulating in the form of dividends, they will wait for the stock market declines to invest that cash at lower prices.
This strategy aims to achieve a superior dollar-cost advantage for dividend reinvestments.
Critics of “timing the market” strategy argue that waiting for market declines is ineffective because the dividend payouts could remain unproductive for too long, neutralizing any potential cost advantage in the long run.
This strategy may be more useful for more active and experienced stock market investors who are able to regularly devote time to study market trends and maintain the discipline to invest quickly during periodic market declines.
Reinvesting in an index fund
Some investors may want to consider reinvesting their dividends from ETFs or mutual funds into an index fund, such as the S&P 500. It is important to note that index funds usually do not pass the dividend income to the investor.
However, if you wish to diversify your stock investments in different securities, you could use your dividends from an ETF or mutual fund portfolio to create a separate indexed holding.
Historical data shows that with dividend reinvestments factored in, an index fund can generate significantly better returns for you over time.
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On top of this, you could consider reinvesting your dividends in a different sector.
For instance, you may use your dividend income from your stocks or mutual funds to invest in a growth-driven sector such as a technology sector ETF with a proven track record of performance.
You can balance your investment portfolio more effectively with this kind of a strategy.
Retirement plan DRIPs
If you wish to buy more stocks of the company that you work for, you could create a DRIP within your employer’s 401(k) plan. This is possible if your plan permits this approach, and if you are prepared to continue to reinvest your proceeds until you retire.
This strategy gives you the advantage of not having to pay taxes on your dividend income until you decide to withdraw from the retirement plan.
In addition, the rule of “net unrealized appreciation” will let you separate your stocks from the remainder of your retirement plan assets and you could sell those at retirement in a single transaction.
Subject to IRS rules, your sale will fetch you a one-time long-term capital gains tax bill, significantly reducing your tax burden.
Concluding thoughts
Dividend reinvestment strategies are almost always beneficial if you are invested for the long-term in the stock market and do not have an immediate or foreseeable need to use the dividend income for expenses.
It’s best to discuss a dividend reinvestment strategy with your financial advisor to determine the strategy for you in the long run.
