How Reinvesting Dividends Is Dragging You Down

| About: iShares Select (DVY)

Summary

Reinvesting dividends does not create wealth, there is a trade-off.

The present value of cash flows would be the same, the time weighted return would be the same too.

The loss of income is a significant drawback.

More importantly, reinvestors would be limiting themselves to a small universe of stocks, missing out on gems like Berkshire Hathaway and Apple.

There is a small benefit during market meltdowns, but there are far better ways to deal with the situation.

Perhaps this is a bit controversial, but I think there is a problem if dividend investors are consistently reinvesting their dividends. Dividend investors (NYSEARCA:DVY) essentially have three choices when they receive cash: spend it, do nothing, or reinvest it. Many dividend investors choose to reinvest their cash receipts (often into the same companies). In doing so, investors can increase their expected income (also reinvested) year after year and watch their net worth grow. We often see graphs like the one below illustrating the difference between an investor who reinvests and one that does not.

Source: dividendmonk.com

According to the chart, the advantage of reinvesting is striking indeed. There is a difference of over $2 million at the end of 40 years! However, this "proven strategy" is not what it seems.

Unfortunately, you don't get to spend your dividends if you reinvest them. So even though the value of your investment account may grow quicker, you miss out on having a better car, a bigger house, or that new iPhone right now. By not reinvesting, you will get to enjoy all the wonders of life today, not 30 years from now. From a more technical perspective, the present value of the two streams of cash flows (reinvesting vs. not reinvest) will be exactly the same. In addition, the time-weighted return for both portfolios will be the same as well, since withdrawals don't count as losses. In essence, reinvesting dividends have a trade-off, there is no free lunch.

But there is a far bigger problem: reinvesting dividends implies self-limitation. The loss of income is quite straight forward, but why would reinvesting dividends be self-limiting? Here's my question to you: if you don't receive the cash (since you are reinvesting), are you still a dividend investor? This is not just a pedantic argument about investor classification, because by definition, dividend investors invest for cash dividends. But since you are not technically receiving the cash (i.e. you are reinvesting), what difference does it make whether a stock pays a dividend or not? Remember, the dividend itself does not create value, as the stock price will drop by the same amount. This means that dividend reinvestors receive as much income (i.e. nil) as a total return investor, but there is a whole new world of stocks that they won't consider because those companies don't pay dividends. To give a rather famous example, you would not have invested in Berkshire Hathaway ( BRK.A, BRK.B) back in 1964, causing you to miss out on the subsequent 1,753,116% appreciation (that's 17,531x your money) over the next 50 or so years. Some contemporary examples include(d) Google (NASDAQ: GOOG), Apple (NASDAQ: AAPL), Gilead (NASDAQ: GILD), or perhaps even Tesla (NASDAQ: TSLA) and Amazon (NASDAQ: AMZN). All of which had better returns than the S&P 500 over the past five years alone, and much higher if we go back further.

Click to enlarge

Now I'm not saying that these are the best stocks in today's market ( SPY, QQQ, DIA), far from it. If they are the best stocks that I could find, they would go straight into the V20 Portfolio. The point is that dividend reinvestors are missing out on potentially lucrative opportunities on a technicality (dividends) that do not apply to them anyways.

One Positive

There is a small upside to reinvesting dividends. Should the market fall into total chaos, reinvestors could benefit as they would be buying stocks cheaply whereas total return investors would not have the cash assuming that they are fully invested. However, considering the amount of dividends one typically receive (say 4%, or 1% per quarter), the actual benefit would be pitiful. Furthermore, you would need the foresight to select great companies that won't be strapped for cash and suspend dividends during a crisis. In any case, practicing risk management from a portfolio perspective (e.g. keeping some cash, gold (NYSEARCA:GLD), short positions) would yield far better results if one intends to take advantage of a market downturn.

Correcting The Problem

The remedy is rather simple, but difficult to implement immediately. Suppose that you are currently receiving $40,000 of dividends annually from a $1 million account; however, you are only spending $10,000, with the rest being reinvested every year. $250,000 of your account would be invested in "essential" dividend stocks to maintain the $10,000 spending need. This means that you could invest $750,000 in non-dividend paying stocks without changing your current spending habits. Of course, it's not easy to reposition 75% of your portfolio in a short amount of time.

While you evaluate new opportunities, you will continue to receive dividends in excess of your spending needs (this is certainly a good problem to have). If you don't have time to study the market too closely, then I believe that you should be doing what you've been doing all along: reinvest. There's reason to have idle cash without an objective. Overtime however, I believe that you should slowly shift your current holdings to your "ideal" portfolio, one that is free of the dividend constraint.

Just to be clear, I don't think anyone should dump their "excess" dividend stocks, that's not what I'm saying at all. However, you should no longer discriminate between dividend paying stocks and non-dividend paying stocks when you source new ideas. You should view dividends as a perk rather than a requirement. The odds are that you will find some attractive investments outside of the dividend stock universe. For example, dividend stocks typically exhibit low growth, but this won't be your constraint anymore.

Conclusion

If you have to think about where you have to reinvest on a regular basis, your income portfolio is producing more cash than you need. It's a wonderful problem to have, but you would be denying yourself countless opportunities. Perhaps you label yourself as a dividend investor, but if you find yourself having to consistently reinvest dividends, I believe that you should really call yourself a total return investor in disguise. So why not take that next step? Embrace it. Delve into non-dividend paying stocks and keep your essential dividend stocks at the same time. Both types of stocks can co-exist peacefully in your portfolio.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.