Recently, I was contacted by a reader named Talgat. He emailed me all the way from Kazakhstan. It's truly wonderful to have readers from halfway across the world! Talgat had a question about dividend reinvestment. I wrote about this a while ago, but I thought I'd refresh this subject.
His question is verbatim as follows:
Dear Dividend Mantra,
I am writing to you from Kazakhstan and am a huge fan of your blog.
I hav (sic) also started my journey because of you.
However, I have a question for you. What do you do with the dividend income that you receive? Do you spend it on daily expenses or invest back to buy more shares? What do you advise me to do?
Great question, Talgat.
Selective Dividend Reinvestment
What I do is I selectively reinvest my dividends. That means I collect my dividends in cash and I reinvest them selectively into equities that I choose. I certainly don't withdraw them out of my brokerage account for expenses, as that would slow the process to financial independence. Any dollar I'm not investing is one less snowflake I'm adding to my compounding snowball. Furthermore, if I need a little extra cash all of a sudden then I would simply deposit less cash into my brokerage account and use it where it's needed.
It's important to remember that cash dividends are just another income source for you. They're seen as an income source by the IRS, and I simply view them as one tool in my arsenal with which to purchase equities. Obviously, one of the main differences between my day job income and my dividend income is that I have to work for the former, while the latter is completely passive. Dividends require no work on my part, which is why I'm trying to build this source of income as soon as possible. The day my dividend income exceeds expenses means I'm financially independent and can do whatever I want with my time.
How I Do It
So my strategy basically boils down to this: I try to save as much money as I can from all of my active income sources (day job, blog income) by living as frugally as reasonably possible. I then pool these savings with dividend income and use the combined sources of capital for my regular equity purchases.
I gross north of $50k/year at my day job, where I work as a service advisor at a luxury car dealership. I also receive some income for writing online, with this blog being my main creative outlet. I try to save as much of the income from these two sources of capital as possible, and then deposit those savings into my brokerage account once per month. This gets combined with whatever dividends have already accumulated since the last equity purchase.
Meanwhile, my dividends automatically accumulate as cash throughout the month. I don't ever withdraw these dividends, but instead use them to supercharge my saved capital and invest all possible firepower. In the end, I think of reinvestment as just a fancy word. I'm simply investing capital, and I'm capital agnostic. Capital that comes from my day job, online income, or dividend income is all the same to me while I'm accumulating assets. However, for purposes of keeping things simple, I think selective reinvestment best sums up my strategy.
Benefits Of Selective Dividend Reinvestment
I selectively reinvest my dividends for a number of reasons.
- I'm able to avoid reinvesting into overvalued securities. By selecting where my reinvested dividends go, I can choose equities that are attractively valued at time of reinvestment, while also keeping a keen eye on portfolio weight and current yield. For instance, right now I think Emerson Electric Co. (NYSE:EMR) is a bit pricey here. It trades at a P/E ratio of 22.32, and that's after a 10% drop YTD. Six weeks ago, EMR was $70/share. I thought that was quite expensive. So my Emerson Electric dividend that got paid on March 10 got reinvested into General Electric Company (NYSE:GE) on that same day because I thought it was a more attractively priced industrial company at the time. Basically, by selectively reinvesting dividends I'm able to allocate my capital as I see fit by having complete control over where my capital goes.
- Taxes are kept simple. Automatically reinvesting dividends through a dividend reinvestment program, or DRIP, can cause nightmares at tax time if you have any stock sales because every time you reinvest a dividend automatically back into the security that paid it out, your cost basis in the originating security is changed. If you DRIP for many years you'll have to keep track of numerous lots of very small stock purchases. I face no such issues, so my cost basis in almost all of my investments is very easy to track.
- My reinvestments are unlimited. By that I mean I don't have to worry about what companies offer a direct DRIP, or which brokerages offer a synthetic version of DRIPing where they will reinvest your dividends automatically for you. I can invest my combined savings and dividends into whatever companies I feel fit at whatever time works for me. I don't have to abide by any rules or worry about whether the company will continue to offer a DRIP for the indefinite future.
- My fees aren't increased. I don't pay more commission costs because I selectively reinvest my dividends. I'm going to invest my monthly savings with or without my dividends, so I'm going to see commission fees through my brokerage for my monthly purchases whether or not I selectively reinvest my dividends. Adding my dividends to my savings simply allows my purchases to be bigger, and therefore my commission costs as a percentage of my capital invested is actually smaller. So, technically speaking, selectively reinvesting is actually lowering my investment costs over time.
Dividend Reinvestment Program (NYSEARCA:DRIP)
While I selectively reinvest my dividends as I see fit, this isn't for everyone. For many people, a DRIP makes a lot of sense. DRIPing means you buy an initial lot of shares with a company and set it up to automatically reinvest your dividends back into the company instead of receiving cash. Basically, you're receiving shares instead of cash at this point. This can slowly build wealth for you over a long period of time without you having to worry about the stock market at all. Your investment is set completely on autopilot.
Buy Stock Direct
A very easy and popular way to do this is with Computershare. This company offers direct stock purchase from a number of companies. Check out the list. There are many companies where you can invest with very little money. ConocoPhillips (NYSE:COP) stock, for example, can be purchased direct through Computershare for as little as $25.00 as on ongoing investment. However, this method is not fee-free. You can view the plan details with COP and see there are fees like $0.12 per share as a processing fee.
Benefits of a DRIP
While I have never personally wanted to set up a DRIP for any of my investments, there are some advantages.
- By reinvesting automatically you're dollar cost averaging (DCA) into your equity investments. You're not worried about the price of stocks with this method, because you're using the power of the dividend payouts from the issuing companies to build your investments for you. Whether the market is high or low, your dividends will get automatically reinvested.
- It takes the fear out of investing. You don't need to worry about pulling the trigger on anything. You can simply buy shares in a company just one time in your life and allow the dividends to reinvest and compound that investment for potentially the rest of your life. No need to incessantly worry about whether it's a good time to buy stocks. It basically automates your investment.
- No special knowledge necessary. You don't need to have any investment education at all to buy stock directly with PepsiCo, Inc. (NYSE:PEP) and set up your dividends to automatically reinvest. It's a no-brainer investment and super easy. While this investment style may not lead to optimal returns over long periods of time because you may be reinvesting in periods of overvaluation, the benefit is the ease.
- Low costs. While not always free, as I mentioned above, setting up a DRIP can be a low-cost way to invest. For example, Scottrade offers what they call "FRIP": Flexible Reinvestment Program. This program allows you to reinvest dividends back into any company, not just the issuing security. And it's all commission-free. So you could reinvest your The Coca-Cola Company (NYSE:KO) dividend into Philip Morris International Inc. (NYSE:PM) because you may think the latter offers a better value, and you could do so without having to pay Scottrade's usual $7 commission. So with this strategy you could pay $7 one time to buy shares in a company and flexibly reinvest your dividends for the rest of your life without having to pay any more fees.
If I didn't invest so regularly I might investigate a DRIP, or even the FRIP for that matter. However, as long as I'm able to save thousands of dollars per month and invest on a monthly basis I'll continue to add my dividends to my savings to maximize my capital firepower. While Warren Buffett hunts with an elephant gun, I hunt with a pellet gun. And my selectively reinvested dividends add a couple more pellets to my ammo.
Full Disclosure: Long EMR, GE, COP, PEP, KO, PM