Why You Shouldn't Automatically Reinvest Dividends

Includes: BAC, JNJ
by: The Conservative Income Investor

At a Berkshire Hathaway (NYSE:BRK.A) shareholder meeting several years ago, Berkshire Vice-Chairman Charlie Munger responded to a question about the very personal nature of investing by posing the rhetorical question: "If economics isn't behavioral, then what the hell is it?". With this in mind, there are two factors in particular that usually make it very difficult for finance writers to make broad generalizations in the realm of financial advice: (1) past performance is no guarantee of future returns, and (2) no two investors share the same psychology and identical investment objectives.

For today, I wanted to look at one of the most sacrosanct tenets of dividend-focused investing: the automatic suggestion that investors should reinvest their dividends. In most cases, this is uncontroversial advice. When a financial columnist encourages investors to reinvest dividends, it's usually about as daring as when a politician says: "I support the troops". You're not exactly going out on a limb by suggesting that putting more money to work can reap its own rewards.

The long-term benefits of dividend reinvestment are probably self-evident, but we might as well take a quick look at a case study to illustrate the point. Let's say that on January 1, 1990, you decided that Johnson & Johnson (NYSE:JNJ) was a good investment, and plopped $10,000 into the healthcare giant to hold for the long haul. If you simply collected the cash dividends along the way to meet your living expenses, the investment would be worth just shy of $57,000 today, plus you would have collected around $18,000 in dividends during that time frame, generating $75,000 worth of value from your initial $10,000 investment.

Had you chosen to reinvest that money back into Johnson & Johnson, you'd be sitting on just north of $119,000. The investor who lived off his dividends the whole time would be currently receiving about $1,990 annually from Johnson & Johnson, whereas the re-investor would currently be receiving about $4,150 in annual dividends, roughly twice the amount of the investor who did not reinvest. Similar scenarios play out for other consumer goods giants like Coke (NYSE:KO), PepsiCo (NYSE:PEP), Colgate-Palmolive (NYSE:CL), or Procter & Gamble (NYSE:PG) over the past 20 years.

While I do have a very strong appreciation of the wealth-building effects of compounding over the long term, I try to maintain a clear-eyed view of how the process of accumulating dividend-growth stocks might play out in my own life. Here's a table on what $10,000 compounding at 10% for 24 years might look like (I say "might" because this assumes a constant 10% annual compounding rate, which would almost never happen in real life).

According to the table, a $10,000 investment would grow to be worth around $110,000 at the end of the 24-year period. That's pretty nice, but there is something very important to keep in mind about the nature of compounding - the big gains do not come until the end of the compounding term. In this example, year 20 through year 23 produced a $30,000 increase - at the beginning of the compounding period, it took from year 0 to year 13 to produce a $30,000 gain.

The last four years of the compounding period produce as much additional wealth as the first 14 years combined. This does not make dividend reinvesting "bad", but it does introduce a variable into the equation that is worth taking into consideration.

This got me thinking about opportunity cost and the proper way I ought to think about dividend reinvestment. If your investing goal is to amass as much wealth as possible, then yes, you should reinvest everything, and you can exit the discussion now. But if your personal goal is to maximize the utility and value of every dollar that you have, then I think that the discussion on this investment strategy gets a little more complicated.

Despite the dividend mania articles that have been cropping up lately, I still doubt that dividend-focused investing will ever become the "It" form of investing, simply because it requires a level of patience and long-term tenacity that is not compatible with the psychology and impulses of a large chunk of the American population.

Sometimes I'll receive correspondence from successful dividend growth investors who note the frustrating nature of compounding with dividend growth stocks - often, you're not loaded until you're an old man! They might have that $5 million fortune at the age of 70, but what they really wish they could do is take that $5 million and combine it with their 25-year-old bodies and stir up some mischief.

I thought about this hypothetical construction when I recently paid $100 for a Bruce Springsteen concert ticket for the March 19 show at the Greensboro Coliseum. And let's pretend that the only way I could pay for this concert would be if I elected to take my Colgate-Palmolive or Kimberly-Clark (NYSE:KMB) dividends in the form of cash, instead of dividend reinvestment. That decision had a very real opportunity cost. It didn't just cost me $100, but it cost me the $100 that I could have invested in Colgate-Palmolive or Kimberly-Clark and watched compound at 9% for 30 years. A hundred dollars invested at 9% for 30 years turns into $1,400 dollars.

At that point, I need to make the decision whether or not seeing Springsteen live is worth $1,400 over the long haul (of course, if you really want to judge opportunity costs correctly, you have to factor in the odds that you'll die before reaping the fruit of your investments, the odds that you'll have a spouse divorce you and turn that $1,400 into $700, etc., so you have to make your peace with a fuzzy guess).

The conventional wisdom with dividend reinvestment is that you should automatically plow that money back into shares of stock or establish a new investment. But I think that this conclusion deserves a nuance or secondary question. Instead of automatically going on autopilot and reinvesting the funds, you should ask yourself, "What will generate the greatest amount of satisfaction and utility for me from this money - spending it now, or spending (hopefully) more later?" There's no right or wrong answer to this question, but I would guess that your overall level of satisfaction with your investments will correspond to how well you answer this question honestly.

And of course, if you are a cynical investor, there is a more practical reason for why you might consider taking the dividends to live off - the stock could conceivably implode in the future, and it's no fun reinvesting into something that could eventually turn into $0. Bank of America (NYSE:BAC) investors who collected their dividends from 1986 to 2007 were able to receive almost triple their initial investment back in the form of dividends, and this can at least offset the significant bruising that occurs when the stock falls to $7 and the dividend turns into $0.01 quarterly.

But of course, most investors do not believe their investments will meet the same fate as Bank of America, and plus, I would guess that many investors would rather be like the hypothetical Johnson & Johnson investor generating $4,000 annually due to dividend reinvestment, rather than only taking in $2,000 due to "eating of the harvest seeds" along the way.

Personally, I'm a big fan of dividend reinvestment, especially since I'm in my 20s and reinvestment has the potential to reap significant benefits for my future self. But if you'll look at the title, you'll notice that I didn't say that investors shouldn't reinvest dividends, but rather, they should not "automatically" reinvest dividends. I think that the discussion of opportunity costs is a variable that has its place in the equation, and it's almost always overlooked when the topic of dividend reinvestment comes up.

If I have a $200,000 portfolio when I'm 30, which is generating $6,000 in annual dividends, I ought to at least ask myself the question: Would I rather take that once in a lifetime European vacation now while I have the full capacity to enjoy it, or would it be better for my 70-year-old self to have an extra $100,000?

These are the types of value judgments I hope that investors consider, and while I lean strongly on the side of dividend reinvestment, I can guarantee you that I will be thinking about the opportunity costs and personal utility factors that are at play every time that hypothetical $1,000 check from Coca-Cola rolls in.

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