Dividend growth investing “DGI” is the strategy of building a portfolio of stocks that pay increasing dividends over time. An important question in DGI portfolio management is what to do with dividends that are deposited into the account; use automatic dividend reinvestment or choose other alternatives?

There are essentially three options for investors to choose from when it comes to dividend payments:

1. Automatically reinvest “DRIP” those dividends back into the company that paid them.
2. Collect the dividends as cash, let them pool up over time, and then self-direct that cash to selectively buy a bigger chunk of stock in either a company you own or into a new position.
3. Take the dividends as income and use them for spending purposes.

I’ve personally used both reinvestment methods while managing my portfolio. When I first constructed my DGI portfolio I chose to automatically reinvest dividends back into the companies that paid them. However, I recently switched to self-directed reinvestment, so I now let dividends build up over time before using them to add to a position.

Either way can be an effective portfolio management strategy. Below, I will share my thoughts on each, and give pros and cons to consider when making a decision on your approach.

Automatic Dividend Reinvestment

Most online brokerages now offer investors the option to automatically reinvest dividends back into the companies that pay them. This is generally done free of transaction costs with no input needed other than the investor checking the reinvestment box.

Automatic reinvestment is an effective way to continue building out your positions over time, especially with higher-yielding stocks. My public portfolio currently holds stock in over fifty different companies. If dividends were pooled and selectively reinvested, I could only add to a few positions in the portfolio per year. However, with automatic dividend reinvestment, I add to each position every quarter, or in the case of monthly dividend payers Realty Income $O and STAG Industrial $STAG, every month.

Dividend reinvestment adds additional shares with each payout, resulting in big impacts to the portfolio over time. I’ve owned Realty Income since June of 2013 when I bought 26 shares. Since then, monthly reinvestment of dividends added another 9.2208 shares to my total. This increased my share count by 35% in just 7-1/2 years.

This increasing share count on top of a growing dividend payout supercharges income growth as it gives you double compounding. You get the natural compounding of a growing payout, but you also get the secondary compounding of an increasing share count.

Realty Income Corp. Case Study

This benefit becomes even more apparent when looking at long-term results. F.A.S.T. Graphs has a helpful tool that shows the price and total returns for companies over varying time frames.

For instance, Realty Income has produced 10.9% annualized returns over the past twenty years, turning a $10,000 investment into $81,530. During this time, investors who took dividends as cash collected $30,105 in total and $2,252 in the final year.

Next, we’ll see how dividend reinvestment can impact those returns over time.

With dividends reinvested the annual return jumps to 14.4%, turning a $10,000 investment into $151,707 rather than $81,531 with dividends taken as cash. The reinvestment of dividends increases the share count from an initial 804 shares to 2,371.9 at the end of the period. This boosts the income produced from $2252 to $6495, which is nearly 3X the base scenario’s income.

The simple act of turning on dividend reinvestment resulted in a Realty Income position that produced nearly 2X the total returns with nearly 3X the annual income than for investors who took the dividends as cash.

The power of compounding share count on top of compounding dividend growth is a tremendous force over time!

Pros of Automatic Dividend Reinvestment

• Builds all positions in the portfolio over time, rather than on a select few per year through directed reinvestment.
• Takes the decision-making out of investors’ hands, making it a low-maintenance investing approach.
• Boosts portfolio income growth as share count compounds.
• Brokerages will typically perform dividend reinvestments for free with zero commissions.

Cons of Automatic Dividend Reinvestment

• In taxable accounts, an investor needs to track and record each transaction for capital gains purposes in the event that the position is sold. Brokerages should track your basis for you, but record-keeping can be difficult with long-held positions.
• There’s no control over purchase time or price. Brokerages make reinvestments on the dividend pay date, with no consideration to stock valuation.
• Reinvestment in losing positions can make losses even worse. Investors who continue to reinvest dividends into companies in secular decline can end up losing everything. If they’d collected the dividends are cash or invested them in other companies they could still salvage something from a poor investment.
• Can lead to an unbalanced portfolio as positions grow larger in size.

Self-Directed Dividend Reinvestment

Self-directed dividend reinvestment is the process of collecting dividends that are paid in a portfolio, allowing them to build up to the desired amount, and then using those pooled dividends to make a purchase of new shares of stock. It is similar to automatic reinvestment in that dividends are buying more shares, but it differs in that dividends are not necessarily reinvested back into the same company that paid them.

The question of whether to invest dividends automatically or by choice often comes down to an investor’s personal preference. However, there are also differences in portfolio characteristics that can also come into play.

Portfolio Considerations

When I originally built my DGI portfolio, I had monthly cash contributions coming into the account. This meant that I could put all of my stock positions on automatic reinvestment and still have cash available to make new purchases every other month from new capital going into the account.

This was the best of both worlds. I could let dividends compound and build up each position, while also having funds to add new positions or rebalance existing ones in the portfolio.

This was also a traditional IRA account, which meant that tracking the basis for each position wasn’t a concern. Taxes aren’t paid until withdrawals are made at retirement, and capital gains aren’t a concern since all distributions are taxed equally.

The portfolio was built before the days of zero-cost transactions, meaning there was a transaction fee associated with every purchase. However, my brokerage didn’t charge any fees for dripping dividends, they were reinvested into new shares for free. This made it a more cost-effective method than selective reinvestment, as a $5 trade commission resulted in 1% of a $500 purchase going to fees.

However, I started a new job in 2017, which meant the cash contributions coming in to my Simple IRA ended. Then in 2019 my broker stopped charging commissions on trades. Those factors and and a wish to be more active in managing the portfolio led me to switch from automatic to self-directed reinvestment earlier this year.

Pros of Directed Dividend Reinvestment

• Allows for the rebalancing of positions without selling or trimming of shares already held.
• Allows for adding new positions in accounts that don’t have cash contributions coming in.
• Makes tracking of cost basis easier for cash accounts that owe taxes on capital gains.
• Allows investors the opportunity to take advantage of price declines and buying what is the best value.
• Can minimize losses in bad investments.

Cons of Directed Dividend Reinvestment

• Reduces the long-term returns of your best performers.
• Can lead to an investor adding to losers that are a good “value” rather than adding to their best performers.
• Results in more fees if the account is held at a brokerage that charges trade commissions.

Closing Thoughts

How to reinvest dividends is a big decision to make when building a dividend growth portfolio. There are many things that need to be taken into consideration when an investor chooses the best option for themself.

In the end, either method can produce positive results over time. The most important thing is to DO the reinvesting, the HOW is more a matter of personal preference.

Here are some articles I have either written or found that provide additional information on the topic:

DRIP Or Rebalance? 25-Year Portfolio Analysis To Answer The Question was a theoretical portfolio of four stocks that looked at the varied results between automatic reinvestment, pooling of dividends and adding to the underweight position, or simply collecting the dividends as cash.

The other two articles come from Seeking Alpha contributors David Van Knapp and David Fish wrote two articles on Daily Trade Alert in 2013 that compared selective dividend reinvestment and automatic dividend reinvestment. They arrived at a similar conclusion that there is no wrong or right way, the important thing is simply to “do it”.

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