Lots of major companies share some of their profits with stockholders by distributing them as dividends on an annual, biannual, or quarterly basis. Additionally, many ETFs and mutual funds include dividend-paying stocks in their investment array.
So, whether you actively pick stocks for your own portfolio or simply invest in funds that pick stocks for you, odds are you’ll eventually end up with some free cash in your brokerage account. So, just what are investors supposed to do with their dividend payouts?
Is It Better to Take Advantage of Automatic Dividend Reinvestment or Hold Onto Cash?
Most brokerages have an option that allows users to automatically reinvest any dividends they receive into whatever stock or fund paid them out, and many take advantage of this option in order to keep their portfolios growing. On the other hand, some investors keep their dividend payouts in their brokerage accounts as cash, which they can either hold onto or invest as they see fit.
So, should you reinvest your dividends or sit on them in anticipation of alternative opportunities? The answer to that question can vary quite a bit based on several factors:
- Your goals
- Your investment style
- Current market conditions
What Are Your Investment Goals?
People invest for different reasons—two of the most common reasons are portfolio growth and fixed-income generation. Dividends can aid investors in reaching either of these goals but in different ways.
Portfolio Growth
Most investors, especially younger folks with active careers who plan to remain invested for a long time, are interested in growing their portfolio’s value to increase their wealth. The main way to do this is to buy stocks and/or funds with the hope that they appreciate in value over time.
Since the goal here is portfolio growth, there’s no reason not to automatically reinvest one's dividends, especially if one's stock picks—and the market—remain healthy (more on this later). Dividends that are reinvested add to existing positions and help them grow even more in value as stocks go up; dividends that sit around brokerage accounts do not.
Fixed-Income Generation
If your investment goal is to create a passive income stream to supplement (or replace) your ordinary income, then you’ll probably pick stocks with high dividend yields and payout ratios that have solid track records of financial health. In this scenario, your dividends will provide some or all of the income necessary for your month-to-month expenses, so you’ll want to hold them in cash rather than reinvesting them. The goal here is to be able to support your lifestyle without eating into your investments’ principal.
Fixed-income investors often supplement their portfolios of dividend-paying stocks with a healthy assortment of interest-paying bonds and combine the payouts from both sources to create an income stream sufficient to cover the expenses of day-to-day life.
This strategy is more common among older investors, especially those close to or in retirement who have had many years to grow their portfolios to such a size that dividend payouts are substantial due to the number of shares of each company owned. Many fixed-income-themed ETFs and mutual funds exist catered specifically to this goal for more passive dividend investors who don’t want to research stocks extensively.
What’s Your Investment Style?
Different investors buy and sell stocks in different ways. Some, like famed fundamental analyst Warren Buffet, evaluate the long-term prospects of stocks, then buy the ones they like and hold them for the long term. Others watch the charts and trade more frequently based on candlestick patterns, support and resistance levels, and other technical indicators.
Whether you should reinvest your dividends may depend partially on which of these two camps you fall into.
Buy and Hold Based on Fundamentals
If, like Buffet, you prefer to analyze stocks based on their fundamentals (P/E ratio, market share, dividend payout ratio, etc.) then buy companies you consider undervalued, you may want to reinvest your dividends. When you plan to hold a stock for the long term, reinvesting your dividends automatically is a great way to increase the size of your position incrementally so that you stand to make more if and when you decide to take profits.
Trade Frequently Based on News and Technical Indicators
If, on the other hand, you trade actively and frequently based on technicals, automatically reinvesting your dividends may not be the best strategy. For technical analysts, having cash on hand is a plus—with cash in your account, you can take advantage of buy signals as you see them appear. By letting your dividends hit your account, you’ll add to your cash position so that you have as much liquidity as possible when it comes time to jump on an opportunity.
How Does the Market Look?
What you should do with your dividends can also change based on market conditions.
Bull Market
In a bull market, when most equities are going up in price, holding onto cash can mean missing out on gains. Considering the opportunity cost, putting dividends back into the market seems like a no-brainer. Whether you invest them in the same stocks and funds they came from should, again, depend on whether you trade in the short term or invest for the long term.
Bear Market
During bear markets and recessions, reinvesting dividends can be risky. According to TheStreet’s Todd Campbell, keeping more of your money in cash than usual is a safe bet when equities are falling, and one way to do this is to refrain from reinvesting your dividends until things begin to turn around. That being said, timing a market bottom is no easy task, and longer-term investors can benefit by adding to their positions as prices fall, so long as they have the money to do so.
The Bottom Line
Ultimately, what you do with your dividends is up to you. Always consider your financial stability, goals, liquidity, and time horizons when deciding what to do with your money. Figure out your style, make a plan, stick to it, and avoid making emotional decisions.
