How Do You Save Money by Reinvesting Dividends?

Dividend investing is different from share value investing. If your investing strategy is to “buy low, sell high” then you pay less attention to when or how often a company pays dividends to its shareholders. Value investing treats the stocks or mutual funds as commodities to be traded and your profit is calculated on a straight-forward basis:

Sell price – purchase price – brokerage commission – taxes = profit (or loss)

With dividend investing you’re buying shares in stocks or mutual funds that pay regular dividends regardless of what their trading prices are. The best dividend investments only pay dividends from real earnings (some companies borrow money to pay dividends). But it still costs you money (above share price) to purchase more shares. This is where Diviend Reinvestment Plans (DRIPs) save you money.

Whereas if you have the dividends paid to you directly before you buy shares, a DRIP automatically purchases fractional shares for you immediately. In other words, your dividends are converted into equity without you having to do anything or pay any trading fees. You are sent a quarterly statement disclosing the dividend you were credited and your new equity balance.

Dividend reinvesting is a great way for people who want to use a “buy and hold” strategy to see the value of their investment grow over 10 years. The growth comes from compounding your dividends over time. And because you’re not paying brokerage fees every reinvested dividend has the potential to increase the value of your portfolio.

The Drawbacks of Dividend Reinvesting Are Simple but Few

Although dividend-focused investment doesn’t much attention to share price, it is still important in some ways. If you buy shares at $10 and 10 years later you are forced to sell them at $8, it’s unlikely you’ll have covered your loss. A company’s stock price may decline only because the market is in decline, but a company that stops paying dividends, reduces its dividends, or which announces a reverse stock split (where outstanding shares are combined into fewer shares) is in financial trouble. Your long-term investment strategy won’t work when these things happen.

What you need to pay attention to is the current market-value of your DRIP portfolio. If the market value declines faster than your dividends can build up value then you may want to move your money into another investment. You will pay a brokerage fee to sell your shares, unless you can sell them back to the company during a stock buyback offer.

The Advantages of Dividend Reinvesting Make It Worth Considering

As investing strategies go, building a DRIP-oriented portfolio is a good idea for investors of all ages. You don’t have to think about where to put your earnings. You still have to pay taxes on them, but you’ll receive a 1099 statement from your investments every year.

A diversified DRIP portfolio protects you from the risks of aggressive investing. Either you can invest in many DRIPs, including some by companies whose stocks grow in price over time, or you can divide your investments between DRIPs and share-value strategies.

Saving money by reinvesting dividends is another way to offset the costs of your aggressive trading. If nothing else, the dividend value may compensate for the trading fees and sell-losses you incur with other trading experiments.

Some Dividend Investments are Better Than Others

Although more than 1,000 U.S. companies offer DRIP investing, they are not all alike. These companies’ share prices rise and fall with their industries, and their own financial successes and troubles affect their stock prices and their abilities to pay dividends.

Dividend Aristocrats are a special class of dividend paying companies. They increase their dividends every year for at least 25 consecutive years in a row. These companies tend to limit their dividends to less than 50% of earnings per share, leaving themselves plenty of capital for future growth. Dividend Aristocrats also tend to be financially stable companies for other reasons. And best of all, they don’t borrow money to pay their shareholders.

Some companies offering DRIP investing may split their shares every few years if the share prices climb too high. What is “too high”? That is determined by each company’s board of directors. They want to attract certain kinds of investors and so they price their stocks according to the budgets and risks of those investors. When a successful company’s stock moves above its preferred trading range, a stock split may occur.

Stock splits don’t normally affect your dividend income. You’ll earn less money per share but have more shares. What one hopes for with a positive stock split is that the company’s earnings will continue to grow and their share price will grow again. A few companies have issued multiple stock splits across their histories, but these splits are serendipitous and may come many years apart.

Even so, if a stock you own splits in a positive way and the share values begin growing again, as well as the dividends, you can reap another benefit by selling some of your shares. When you make the sale in one transaction the brokerage fee won’t affect your profit much.

The Intrinsic Savings You Find in Dividend Reinvesting Strategies

The greatest advantage to “buy and hold” investing based on automatic dividend reinvesting is without question the fact that you are less tempted to sell your stocks. People usually put DRIP stocks on a back burner, so they incur fewer trading fees and may only add more money to their investments over time.

If you’re interested in value-based trading you’ll look for stocks or mutual funds with highly volatile share prices. While these kinds of securities may pay dividends, they are less likely to support DRIP investing. Some companies encourage speculative trading in their stocks because they reward shareholders with buybacks. Buybacks return value to investors and help keep stock prices high, but companies are more likely to finance buybacks with debt than they are to finance dividends.

Debt-based buybacks and dividends are frequently called out by critics of the practices. Research shows that debt-based stock buybacks are declining, but they could return when the economy becomes recessionary.

When you invest in DRIPs, you’re less concerned about where the money is coming from as long as it keeps coming and the share price doesn’t decline to the point where your investment’s market value becomes unprofitable.