There is a good, easy to understand article in the NYT about the advantages and disadvantages of reinvesting dividends you receive from stocks, ETFs, and mutual funds. Here are some highlights, as well as some of my own additional comments:
Why You Should
- Automatic dollar cost averaging: by this I mean you are buying into the market over time and rather than all at once. This helps limit volatility and theoretically attempts to purchase shares at the best average cost.
- No more tax calculation headaches: new tax rules require brokerage firms to track your tax basis. Thus, they will automatically adjust (increase) your tax basis for dividends.
- Easily comparable rates of return: when you look at your return, you don’t have to add back dividends. In fact, the Morningstar return assumes dividends are reinvested.
- Commission free purchases: if you pay commissions for purchases, this is a way to avoid them.
Why You Shouldn't
- You need the income: you are foregoing the income generation that dividends brings.
- Taking earnings off the table: by taking the proceeds in cash, you can potentially reduce the volatility that the market can bring.
- Portfolio rebalancing: taking dividends in cash allows you to re-balance your portfolio with that cash.
- Possible concentration risk: by reinvesting the dividends you are increasing your exposure to that position.
- Phantom income: reinvesting the dividends generates tax, but not the cash to pay the tax.
As with everything else, the correct answer depends on the investor’s goals, objectives and possibly risk tolerance.
A retiree who needs cash is probably better served by using the dividend income to support his or her lifestyle. A younger investor who has a long time horizon may better be suited by reinvesting the dividends as he or she likely doesn’t need the cash and volatility is less of a concern given the time horizon.
