So you have another dividend coming and are wondering whether you should reinvest it or take the cash? Reinvesting a dividend is when instead of taking cash, that money is used to buy more shares of the stock. There are advantages to reinvesting dividends, but also some potential dangers. Advantages include dollar cost averaging and compounded dividend growth. Disadvantages include the dividend being suspended and giving up the opportunity to use that dividend cash for something else. You don't always need to reinvest your dividends. Weighing the pros and cons, relative to your personal situation, will help you determine whether you should reinvest.
Dollar Cost Averaging
An advantage of reinvesting your dividends is something called dollar cost averaging. Since the amount of your dividend is generally a fixed dollar amount, multiplied by the amount of shares you own, as the price of the stock fluctuates, the amount of shares you can buy with the dividend also changes. As you reinvest, your purchases of the stock are spread out over different prices. If the price of the stock is dropping and you reinvest your dividends, you will be able to buy more shares at the lower price. This reduces the cost base of your position. If the stock goes up, you will be making money on the dividends you reinvested previously and will buy fewer shares at the higher price with the dividend received.
Reinvesting your dividends means that your position within the stock grows. The larger position in turn means you collect a bigger dividend check, which again can be reinvested. This is known as compounding -- when you earn dividends on your initial investment and also dividends on top of prior dividends. Over time the compounding of your dividends can be significant.
Dollar cost averaging and compounding returns can be seductive, and as long as the company remains financially solid, reinvesting has advantages. Companies don't always remain financially solid though, and it is possible the dividend could be suspended or the share price tanks. If the dividend is suspended, you will no longer benefit from compounding dividend payments. Dividends may be suspended for multiple reasons but often signal financial difficulties for the company. Difficulties are usually associated with a significant drop in share price. When a major price drop occurs, or the company goes bankrupt, dollar cost averaging will not matter, as the current share price will be far below the price you paid for the shares.
If you have no better place to put your capital than in the stock(s) you already own, then reinvesting is likely your best choice. Yet every time you reinvest a dividend there is an opportunity cost. By reinvesting you are giving up the opportunity to use that money somewhere else. If there are other investments that could yield more than reinvesting, you are better served by taking the dividend in cash and investing it in an alternative. The dividend could also be used to pay off high-interest debt, reducing your monthly expenses.
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