To Reinvest or Not to Reinvest? That is the Question
by Dan Federman, CFP(r)
Investors who buy individual stocks, mutual funds, or Exchange Traded Funds (ETFs) are faced with the choice of whether or not to reinvest dividends (or capital distributions) back into the respective stock, mutual fund, or ETF. To be clear, this is entirely a matter of personal preference. Assuming the investor needs income, the choice may seem obvious. But what about when the investor does not need income?
In spite of some statistics showing that an investment in the S&P 500 WITH DIVIDENDS REINVESTED produced 8x the return (since 1950) as that of an investment in the S&P 500 WITHOUT DIVIDENDS REINVESTED, 0ur preference and recommendation to our clients is to take the cash rather than reinvest into the security.
There are a few reasons we prefer to take the cash rather than reinvest:
First, is diversification. Cash is a separate asset class apart from stocks, bonds, real estate, oil & gas, precious metals, etc. By allowing cash to build up, it will eventually reach a percentage of the portfolio greater than the recommended target level, creating a trigger to rebalance the portfolio by investing the cash into one of the other under-weighted asset classes such as stocks or bonds.
Second, is administrative hassle. Reinvesting dividends back into stocks or funds causes an investor to accumulate fractional shares and can create an administrative nightmare when tracking cost basis for tax purposes if/when someone decides to sell his/her investments.
Third, is risk. By reinvesting dividends into a mutual fund or individual stock, an investor may be increasing his/her risk by accumulating too much of a particular risky investment. This risk is more pronounced, in our view, when reinvesting dividends back into individual stocks or into retail mutual funds run by managers with unusual “hot streaks” of “market outperformance.” As an example, consider all the bank stocks that paid dividends for so many years, and then collapsed in the financial crisis of 2008. Anyone who had been reinvesting all their dividends into these banks would have lost most, and in some cases, all of their wealth. Unfortunately, there were people who viewed bank stocks as “safe.” Similar things can be said of utility stocks AND “5-star mutual funds with good track records.” Always keep in mind that past performance is not an indicator of future results.
So, if you’ve been reinvesting your dividends into your investments for years, consider these points. You may not be diversified enough, you may be creating an administrative headache for yourself or your CPA, and you may be increasing your risk unintentionally.
To get a free portfolio review, contact a financial advisor at Ariba at 1-800-808-7488 x101
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