Dividend Growth Investing Lesson 10: Two Ways to Reinvest Your Dividends to Enhance Your Returns

Note from Daily Trade Alert and Dave Van Knapp:
This 2018 revision of DGI Lesson 10 condenses the original two-part Lesson into a single lesson that discusses both ways of reinvesting dividends: Selectively and automatically. The segment on automatic reinvestment was originally written by the late David Fish, who created the wildly popular Dividend Champions, Contenders and Challengers (CCC) list in 2008 and maintained it until his death in 2018. Much of David’s original discussion of drip investing remains in this revised lesson. The dividend investing community owes a great debt of gratitude for David Fish’s expertise, his willingness to share it, and his creation of the CCC.

In DGI Lesson 5, we discussed the power of reinvesting dividends. We saw that:

1. Reinvesting dividends adds a layer of compounding to your dividend stream. Reinvested dividends buy new shares, which produce their own dividends, in repeating cycles of growth and reinvestment that cause your ownership stakes to rise.
2. The compounding from reinvestment accelerates the growth of your income stream beyond the growth that comes from the companies’ annual dividend increases alone.
3. Compounding from reinvesting dividends causes your dividend stream to rise geometrically. The gap between reinvesting dividends and not reinvesting them widens as more years pass.

In this lesson, let’s come down from the mountaintop and talk tactically about the two ways that you can reinvest your dividends. You can:

• Collect dividends in cash and then selectively target reinvestments. I do that in my Dividend Growth Portfolio.

• Have your brokerage automatically reinvest each dividend as soon as it’s available. Each dividend goes to buy more shares of the company that paid it. That’s what Mike Nadel does in DTA’s Income Builder Portfolio. My wife and I also do it with some positions in our private investments.

Method 1: Selective Reinvestment

I should note at the outset that selective reinvestment is probably the less-used way to reinvest dividends. The method used by most dividend growth investors is automatic reinvestment, which will be discussed later in the article.

To illustrate selective reinvestment, here is how I do it in my Dividend Growth Portfolio (DGP).

1. I allow dividends to accumulate in my brokerage account to a certain amount that I have predetermined. Currently that amount is $1000, which is about 1% of the DGP’s size.
2. When the $1000 threshold is reached, I go shopping for more shares. I might look for a new stock, or I might add to an existing position.
3. I put as much thought into what to buy with the accumulated dividends as I would put into buying shares with new outside money coming into the portfolio.

There is nothing magic about $1000. It is just a nice round figure. Since my DGP has a current yield of just under 4%, that means that it currently delivers about $3900 per year in dividends. Thus I can go shopping (with $1000) about 4 times per year.

For an example of how it works, let’s look at my most recent reinvestment: I bought 19 shares of Altria (MO) for $1053 in May, 2018.

The main reasons I selected MO were these:

1. It allowed me to start a new portfolio position in an iconic dividend growth stock without adding new money to the portfolio. All the dividends used to buy MO came from other companies.
2. MO is a high-yield stock (5.1% when I bought it) that immediately added significantly to the DGP’s income stream.
3. For the first time in years, MO was decently valued. I didn’t have to over-pay for it.

I purchased MO by entering a simple market order, using the dividend cash already in the account to pay for it.

Method 2: Automatic Reinvestment

This is the more common way to reinvest dividends. You set it up with your broker to reinvest dividends automatically, as soon as they are credited to your account, into the same stock that issued them.

Automatic reinvestment is usually called “dripping.” A little background helps explain that term. The acronym DRIP stands for Dividend Reinvestment Plan.

There are two basic types of DRIP. If you look back 25 years or more, DRIP primarily referred to company-sponsored Dividend Reinvestment (and Stock Purchase) Plans.

These were arrangements set up directly between companies and investors.

Under these DRIP plans, an investor had shares registered in his or her own name, rather than in “street name,” which describes stock ownership in a brokerage account.

One benefit of the original DRIPs was that individuals could own stock in various companies without needing to open a brokerage account.

What’s more, company-sponsored plans allowed participants to make additional (optional) cash purchases, a benefit that exists to this day.

So, for example, a small investor could invest (via check and later, electronically) $10, $25, or $50 in dividend growth companies like 3M Company (MMM) or Johnson & Johnson (JNJ).

Beginning in the mid-1990s, the major brokerages launched programs to rein in as much of those assets as possible. The primary pitch was that investors could reinvest their dividends – usually for free – in their brokerage accounts, so dealing with all that paperwork was unnecessary.

As time went on, the brokerages’ drip plans gained increasing acceptance. Meanwhile, some companies began adding fees to their DRIP plans. Naturally, these added costs led to a decline in the popularity of company-sponsored DRIPs, to the point where many people are unaware of their existence.

Nowadays, most brokerages make it as easy as checking a box to initiate a free dividend reinvestment plan. I have accounts at E-Trade and Schwab, and with each it’s just a matter of checking the right box.

At E-Trade, they state that when a stock you own and have enrolled in a DRIP pays a dividend, those funds are automatically invested in additional shares of that company’s stock instead of being deposited into your account as cash. They explain how the purchase date and share pricing are determined.

This display, from my Dividend Growth Portfolio account, illustrates how easy it is to check a box and enroll your shares in their DRIP program:

I could check any box, or all of them, and those stocks would immediately be enrolled in E-Trade’s DRIP program.

At Schwab, where my IRA resides, they ask you one security at a time:

Both brokerages allow you to select dividend reinvestment at the time you buy a security, as well as later after you already own it. You can switch back and forth whenever you want.

Comparing the Two Methods of Reinvesting Dividends

There is no “right way” to reinvest dividends. Selective reinvestment and automatic reinvestment are two ways to skin the same cat: You want your reinvested dividends, over time, to accelerate the building of:

• your asset base;
• your wealth;
• your dividend streams.

Whether you choose selective reinvestment or automatic reinvestment of dividends, the result is that your portfolio consistently increases the number of shares of companies that you own.

Let’s compare the two methods:

Many dividend growth investors use both methods within a single account. They drip some stocks or ETFs while just collecting the cash from others. Some turn drips on or off as the valuations of individual stocks change.

Either way, reinvesting dividends causes share counts to rise, and since dividends are paid per share, it causes your dividend stream to rise too.

Key Takeaways from this Lesson

1. There are two ways to reinvest dividends: Selectively and automatically.
2. In selective reinvestment, you collect dividends in cash until a certain “trigger” amount (of your choice) has been accumulated. Then you select a stock to buy and enter a purchase order for it.
3. In automatic reinvestment – also known as “dripping” – you check a box that instructs your brokerage to automatically reinvest dividends in the stocks that paid them.
4. You can switch back and forth between the methods whenever you want.
5. Within a single account, you can employ both methods at once: Some stocks can have the drip turned on, while others can have it turned off.
6. No matter which method you use, you will get the universal benefit of compoundingCompounding means to make money on money already earned. The “money already earned” is the dividend stream. You compound it by reinvesting the dividends to purchase more shares and get more dividends. Either method accomplishes that.

— Dave Van Knapp