As a new investor, you'll have a few important questions to address. One of them: Will you treat the dividends you receive from your stocks as extra income? Or will you reinvest them for future growth?
Treating dividends as income and reinvesting them are both viable investment strategies. Each comes with trade-offs that impact your ultimate net worth and the lifestyle you are able to lead.
How to Reinvest Dividends
When you receive dividend payments from a stock that you own, you have two options:
- Treat dividends as income.
- Reinvest dividends to buy more of the same stock.
Many stocks have dividend reinvestment plans (DRIP); these allow you to buy more shares of the same stock by automatically reinvesting them rather than being deposited into your checking account.
DRIP plans are helpful to small investors because they allow you to buy fractional shares.
Not all companies allow this option. And not all investors choose to reinvest, even when it is available. Which choice is right for you depends on your own short- and long-term financial goals.
What Happens When You Don't Reinvest Dividends?
When you don't reinvest your dividends, you increase your annual income, which can significantly change your lifestyle and choices.
Here's an example. Let's say you invested $10,000 in shares of XYZ Company, a stable, mature company, back in 2000. This allows you to buy 131 shares of stock at $76.50 per share.
In this instance, you do not reinvest your dividends.
By 2050, you own 6,288 shares as a result of stock splits. It's now trading at $77.44 per share, or a $486,943 market value for your entire position. Over those 50 years, you also receive dividend checks totaling $136,271. Your $10,000 turned into $613,214.
While not sufficient to replace a full-time income, your dividends in this scenario would provide a large amount of extra money. It could be used for emergencies, vacations, or education; or, it could simply supplement your regular income.
On top of that, you would ultimately have $486,943 in shares sitting in your brokerage account. This could generate significant additional dividend income. It could also serve as a large portion of your retirement income.
What Happens When You Do Reinvest Dividends?
When you do reinvest your dividends, you lose the additional cash flow that they could have provided in your daily life. However, you benefit from even more significant compounding. As your dividends reinvest, they buy additional shares, which then generate additional dividends, all of which are also reinvested.
Let's go back to our example above. Back in 2000, you invested $10,000 in shares of XYZ. You bought 131 shares of stock at $76.50 per share.
This time, you set your dividends to reinvest.
By 2050, your 131 shares have grown into 21,858 shares. Because the value of the company has gone up, the market value of your stock is $1,700,000. You retire and start taking annual cash dividends of $42,000.
In this scenario, instead of enjoying extra income over the course of 50 years, you delay using the money from your investments until you retire. At that point, your initial investment of $10,000 has become nearly $2 million. This could fund a very comfortable retirement.
Is It Better to Reinvest Dividends or Not?
Would you rather enjoy over $136,000 in cash along the way? This could allow you to pay unexpected expenses or take vacations with your family. And you could still end up with investments worth a sizeable amount.
Or, would you rather live more frugally for most of your life, but have $1,700,000 and a large annual cash dividend in retirement?
The right answer depends on your financial situation. It also depends on your short- and long-term goals, your personality, and your need for funds. If you make a comfortable income and don't feel the need for a lifestyle upgrade, reinvesting your dividends to fund your retirement could make the most sense.
If you choose to reinvest your dividends, you can still sell stock to cover unexpectedly large expenses; these could be items such as a child's education or a medical emergency.
On the other hand, what if you need a little extra income to supplement your job? Or what if you want to enjoy more experiences while you are young (or for your family while your children are young)? In that case, you could be better off using the dividend payments throughout your lifetime.
In that case, you would still end up with nearly $500,000 in your brokerage account and the annual income from those dividends.
The right choice for you also depends on your level of risk tolerance. In a best-case scenario, you can maximize the value of your investment by reinvesting your dividends. But if the company goes under or the stock market crashes, you could lose your investment just when you need it most—without even having the chance to enjoy the benefits of your dividends along the way.
Ultimately, whether you reinvest your dividends or spend them, you should be using your money and investment as tools to provide you with the highest possible balance of enjoyment and security throughout your life.