I often get asked this question from clients who are curious about whether it is a better strategy to reinvest your dividends back into the securities that distributed them or have them pay to cash? The answer really depends on what your needs are and what your long-term strategy is for the investments that are providing this income. My personal preference (and what I do with my own accounts) is to have the dividends reinvest. This accomplishes two simultaneous goals:
1. You are able to increase your total portfolio allocation to the fund that is paying the dividends and thus increase the amount of future dividend payments.
2. You are continuing to compound your total return in the original investment by acquiring more shares that may rise over time.
However, this strategy is not always the best option for everyone. If you are retired, and living off of the dividend distributions from your investments, it may make more sense to have them pay to cash in your portfolio. Then on a monthly or quarterly basis you can have the proceeds swept into your checking account. This gives you the liquidity and flexibility to put the cash to work for your every day expenses or look for other investment opportunities with the additional funds.
In addition, if you are planning on only owning an investment for a short period of time, it may make better sense to have any dividend proceeds deposited as cash so that you don't have to worry about additional settlement times or fractional shares.
Either way with today's brokerage accounts you have the ultimate flexibility with your dividend payments. Many brokerage accounts let you select what option you prefer when you setup the account (either reinvest all dividends or pay to cash). In addition, if you select "pay to cash" at the account level, they even give you the ability to have specific investments reinvest at your discretion.
Dividend Reinvesting with ETFs
Many people are aware that mutual funds pay dividends and you are able to reinvest these proceeds back into the fund by opting to purchase additional fractional shares in lieu of cash, but did you know that you can do the same thing with many ETFs as well?
It is a little-known fact that brokerage companies will allow you to own fractional shares of many ETFs. When a dividend is declared, your broker will do the math and acquire fractional shares for you on the day that the fund company pays these proceeds. This allows you the benefits of reinvesting that was previously only available for mutual funds and DRIP stock plans.
One of my favorite dividend ETFs that allows reinvestment is the iShares Multi-Asset Income ETF (BATS:IYLD). This exchange traded fund is essentially a "fund of funds" that purchases a basket of other iShares dividend paying stock and bond ETFs. The fund has an asset allocation that is approximately 50% domestic bonds, 10% international bonds, 25% domestic stocks, and 15% alternative assets.
I love this strategy because you are able to get instant diversification and liquidity with just a few well-known underlying holdings. The fund has a balanced weighting between stocks and bonds that keeps the income quite high (as of this writing the SEC yield is over 5%), and price volatility low. The dividends from IYLD are distributed on a monthly basis but typically the distributions tend to be higher at the end of each quarter as the dividend stock components add to the yield.
IYLD is a perfect example of a core income holding that you can utilize to reinvest dividends on a monthly basis.
Additional disclosure: Client of my firm may own this security in their brokerage accounts.