Most readers might be aware that I do not automatically reinvest dividends in my taxable brokerage accounts. I usually have distributions accumulate up to a certain amount in cash, and then combined with fresh contributions I tend to purchase stock in companies which I believe to be good buys at the moment. That way, I am able to allocate my cash into the best ideas I can find at the moment.
I also do that because I do not want to buy partial shares in many companies regardless of valuation. I therefore do not do automatic reinvestment. In addition, I avoid it, because it would be a nightmare to figure out taxable amounts, should I decide to sell the security. Imagine buying 100 shares of a stock like Phillip Morris International (NYSE:PM), and then receiving the equivalent of one share every 3 months. Try doing this for 10 - 20 years, and now you have something like 40 - 80 individual transactions you need to take into consideration when calculating taxable basis, should you decide to sell.
As I have started accumulating funds in my tax-deferred accounts however, I am doing the exact opposite. For example, in my Roth IRA portfolio I started in 2013, I turned on the function to automatically reinvest dividends in the same security. I am using Roth IRAs in this example because Roth's have a fixed dollar contribution amount, and therefore this discussion could be relevant to more readers.
With $5,500 in annual contributions, the maximum amount of annual dividend income would be somewhere between $165 - $220. I could accumulate the cash for one year, and then purchase a security. Unfortunately, investing such a paltry amount in a locked account such as a Roth IRA would be prohibitively expensive. I have mentioned before that I do not want to spend more than 0.50% on commissions at a time. Even with a $4 commission, this equates to 2% on invested funds. If I accumulate cash from dividends to make a purchase where commissions are less than 0.50% of investment value, I might have to wait for almost four or five years. Therefore, it does not make much sense to accumulate a lot of cash in a portfolio to make one investment, unless of course no adequate investment opportunities are available.
The other reason for automatic dividend reinvestment is avoiding pressure. The pressure to select the perfect investment would be much greater, when you can only make one investment per year. I would have much more safety in my reinvested dividends, if I put them in several companies, as opposed to just one. This is because with $200 or so in annual distribution amounts, it would be prohibitively expensive to put distributions in several new ideas, versus reinvesting them back into the companies that paid them in the first place.
In addition, I am eligible to make contributions only once a year for my Roth IRA. This is because you can only put $5,500/year, and because of commissions it makes sense to invest the whole amount within two months or so. Thus, I would have to wait for several months, and accumulate cash for the annual contribution before I could make the contribution for the next year. Therefore the paltry initial amount of dividends (the $165- $220) could translate in accumulation of cash that is not helping in my long-term compounding of profits. I would be much better off in automatically reinvesting the dividends into the same security that paid them.
When you reinvest dividends immediately after receiving them, you are essentially starting the compounding process. This compounding process is particularly powerful when you reinvest dividends from a company that grows them over time. Your dividend will snowball and grow because of that. Waiting to reinvest for a few years, could prove costly in the long run. The only reason that you might not want to reinvest distributions automatically is if the underlying security is grossly overvalued. For example, if you owned Wal-Mart (NYSE:WMT) stock in 1999 when it was selling for 30-40 times earnings, it would have been a crime to reinvest distributions back into the stock until the beginning of the Financial Crisis.
Once I accumulate the necessary scale however, the strategy could change dramatically. For example, if a Roth IRA generates $5,500 in annual dividend income, it would be essentially self-funding itself from distributions alone. If our dividend investor is also eligible to contribute $5,500 annually to the account, we would be dealing with essentially $11,000 available to invest throughout the year. If we can keep commissions to $4/trade, we can potentially make as many as 13 - 14 transactions/year. Therefore, it might make more sense for this account to accumulate cash from distributions and contributions only after sufficient scale is achieved. Then the money would be used to allocate into an attractively valued security at the time, one investment per month or so.
To summarize, it might make more sense from a cost/benefit perspective to automatically reinvest funds in the same security, if you do not have a large portfolio. However, once you reach a certain scale, it might be best to accumulate distributions in cash and then make investments at the best values you can find at the time. Because I am building up my scale in tax-deferred accounts right now, it makes sense to reinvest automatically there. For taxable accounts however, I group dividends received with contributions, and allocate the money in the best opportunities at the moment.
Disclosure: I am long PM, WMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.