In this article we will examine whether you should spend or reinvest your dividends.
You recently bought a dividend ETF or stock and received your first dividend payment. Congratulations, you are now a certified dividend investor!
The question now is should you cash out your dividend or reinvest it?
The answer is, well, it depends.
Here’s the breakdown.
Once received, a dividend can be used in one of two ways:
- Wired immediately to your bank account so you can spend it.
- Reinvested, either into the same stock or into another financial product.
Let’s examine under which circumstances you should spend or reinvest your dividends..
1 – CASHING OUT THE DIVIDEND
Many investors buy dividend paying products to generate regular income that will complement their lifestyle.
With that goal in mind, cashing out your dividends to spend the money right away is very tempting. However, this only makes sense in the following scenarios.
i) High net worth individuals who receive substantial dividend payments
Very high net worth individuals whose positions generate substantial dividend payments can cash out their dividends to fund their lifestyle.
If an investor has $5 million invested in a dividend product yielding 4% yearly, that represent a payment of $50K per quarter. This investor can reasonably cash out the dividend to finance his lifetyle.
Investors who are nearing retirement age or who are already retired can cash out their dividends to complement their retirement income.
They worked hard, saved and invested their whole life to be able to enjoy the fruits of their labor once they exit the workforce. If they invested for several decades, they should have built a nice portfolio which yields a sufficient amount to live off of until the rest of their life.
iii) To reinvest elsewhere
Lastly, you can cash out your dividends if you want to diversify your investments or finance a personal project.
For example, you can use the dividend money to invest in real estate, precious metals, cryptocurrencies or to finance a personal project.
In sum, it’s recommended to cash out your dividends if you’re retired and need the income, if your dividend payments are large enough to justify withdrawing, or if you wish to reinvest those funds elsewhere.
However, for most investors, there are many drawbacks to cashing out your dividend payments. For them, it’s perhaps preferable to reinvest your dividends.
2 – DIVIDEND REINVESTING
For the average investor, the first dividend payments are quite small. Often, they are counted in cents or dollars.
You’ll agree that it makes little sense to cash out a paltry $5 or $10 quarterly dividend payment.
Instead, you should consider reinvesting your dividends. Most companies offer “Dividend Reinvestment Plans (called DRIP) that automatically reinvest your cash dividends into additional shares or fractional shares of the underlying stock on the dividend payment date. Also, many ETFs automatically reinvest the dividends for you; these are called accumulating ETFs.
Reinvesting your dividends allows you to benefit from the power of compound interest, a phenomenon that Einstein dubbed the “eighth wonder of the world”. In his words, “He who understands it, earns it… He who doesn’t… pays it”.
The beauty of compound interest is that the interest is calculated on the initial principal and on the accumulated interest of previous periods. Think of it as “interest on interest” which makes your invested money grows to a higher amount at a faster rate than simple interest, which is calculated only on the principal amount.
This graph shows the difference of returns between simple and compound interest. In the hypothetical example, over a 50-year period there is a 9-fold difference between the returns.
In a nutshell, compounding is the value of time, a reward for delayed gratification. It is arguably the most powerful tool in an investor’s arsenal.
If you reinvest your dividends, you’ll be able to buy more shares of the dividend paying stock, which will increase your next dividend payment. The increased dividend payment will allow you to buy even more shares of the product. After several years of following this strategy, your dividend payments will become so big you’ll be able to buy several shares of the dividend paying stock for FREE, which will provide additional income, and your dividend payments will increase exponentially. After twenty or thirty years of following this strategy, you’ll be buying large quantities of stock for free.
Examples of compounding in action.
The following scenarios illustrate the power of compounding
i) An 18 year old invests $250 a month every month into SPY index fund (S&P 500 ETF) until he/she turns 65, assuming a 7% rate of return. If he invests $250 par per month, he’ll be a millionaire by age 65
If he starts at the age of 30 (which is the average age to start investing in the US), after 34 years of investing, his total returns amount to $417K
Granted, it’s very difficult for an 18 year old to invest $250 every month. Most are studying in university and have just taken out huge student loans. Naturally, they aren’t thinking about investing yet. Worse, when they receive their first paycheck, they experience the joy of participating in the hyper consumerist society. Once they initiate the spending cycle, it’s very difficult to break.
However, it’s never too late to start and some wealth is always better than no wealth.
In case you’re still skeptical of the power of dividend reinvesting, here is some research that proves that dividend reinvesting maximizes returns over time, beating the returns of investors who cash out their dividends.
Dividend reinvesting beats non-dividend reinvesting.
The majority of the S&P 500’s returns have come from dividend reinvesting. In fact, dividend reinvesting beats the overall market returns by a very wide margin, whatever the time horizon considered.
Investment company Hartford Funds published an exhaustive article illustrating this over several time periods.
The Long-Term View: Since 1930, 42% of all S&P 500 returns are attributed to dividend reinvestments.
Decade by Decade: Dividends played a much more important role from the 1940s to 1970s and played a much smaller role since the 1990s. However, during the lost decade of the 2000s, when the total S&P return was negative, dividend reinvesting provided positive 1.8% annualized return.
To give you an idea of what this means in terms of total dollar returns, let’s look at the following graph, which tracks the performance of a $10K investment in the S&P 500 from 1968-2018. If the investor chose not to reinvest his dividends, he ended up with $431,397. If, on the other hand, he decided to reinvest the dividends, he ended up wth $2,459,158. The difference between reinvesting and cashing our results in a $2,027,761 difference.
In sum, it is beyond doubt that dividend reinvesting beats non dividend reinvesting.
The effects of compounding are hard to notice at first, but once you enter the second and third decades your returns accelerate quickly, unleashing the full force of compounding..
Dividend investing is definitely not a get rich quick scheme. In fact, it’s everything but.
It’s a get rich slow scheme which requires patience and discipline.
Furthermore, you need to do your due diligence to invest in the right products.
Dividend paying ETFs are a great place to start your dividend investing journey. Read this article to discover 3 ETFs to start dividend investing. Dividend Aristocrats are also excellent dividend investments.
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DISCLAIMER: This article is the fruit of my personal research and should not be viewed as financial advice. I enjoy analyzing stocks and providing investment ideas but I highly encourage you to conduct your own research before investing in any asset. NEVER invest without having done proper due diligence and NEVER invest out of the Fear Of Missing Out (FOMO). Also, NEVER invest because some internet message boards are hyping up a high-flying stock. As a rule of thumb, the number of rockets included in a tweet are inversely proportional to the quality of the advice given.