What You Don't Know About Dividend Reinvesting Can Hurt You

For many individuals, reinvesting dividends may be among the most obvious and automatic rules for building wealth, and with good reason — it can be an easy way to get more shares of the funds or company stock you already own, often at a lower cost than buying new ones using your trading account.

Whether you notice it or not, the dividends you’re paid are often reinvested automatically for you, especially if you own mutual funds. These dividend payouts are an increasingly important part of the average person’s portfolio, with bond yields near historic lows.

Companies are paying record levels of dividends. The Standard & Poor’s 500 index companies have sent shareholders $US300 billion worth in the last 12 months, according to S&P data. The average dividend yield is a bit over 2.5 per cent, and people have flocked to dividend-paying stock funds as they abandon bonds. Many brokers manage the reinvestment transactions for the shares their clients hold, helping reduce paperwork for the programs, which can be daunting. Fund companies nearly always offer them for the funds they sell investors.

But be careful. Dividend reinvesting, sometimes done through dividend reinvestment plans, or DRIPs, can be a drain on your savings if you are not handling payouts the right way. Many people are not even aware of what happens to their dividends when they land as cash in their accounts. Taking a look at how your account is set up to manage fees and optimise payouts can add up to serious money in the long term.

[See: 10 Target Date Funds Producing High-Grade Nest Eggs.]

Here are things you can do to make sure you are making the most of valuable dividends.

Make sure you know how your dividends are paid. It sounds simple, but a lot of dividend payouts are wasted or misused. You can set up your account so the payments go directly into a money market — where yields are near zero now but you have access to cash when you need it. Or they might be automatically reinvested in the fund or individual stock.

“The reinvestment election can be selected or de-selected at any time,” says Steve Balaban, a financial advisor at Williams Financial Group. It’s true for mutual funds, both equity and debt, and for individual stock positions, he adds. Bond dividends arrive as cash payouts that normally are not part of a DRIP unless you are a very large investor.

The choice can be automatic, but the decision should not be. Whether you reinvest dividends should depend on your overall investment needs. The reinvestment should reflect whether you are building your savings or nearing the time you need the income.

“If you are investing for the long term, then reinvesting dividends is usually a good idea,” says Arden Rodgers, financial advisor and principle of Arbus Capital Management LLC. “Dividends provide a large part of the total return of equity investments.”

[Read: 3 Ways You May Be Throwing Away Money Without Realising It.]

Watch out for hidden fees. Sometimes you will be charged for reinvesting dividends in a company’s stock if you’re participating in a DRIP. Even if you are getting a discount on the share purchase of 2 per cent to 4 per cent, a commission for those reinvestment purchases of the shares could be added to the cost and could eat away at the discount.

While there is often not a direct fee for participating in a DRIP and it’s usually cheaper than buying shares on the open market, there may also be a transaction fee for acquiring the shares for your account. Some reinvestment plans will deduct some of the dividend payment to cover fees. Brokers each have their own way of handling such costs, so you will need to check.

Also, don’t forget to consider the “opportunity cost” of reinvesting in the same fund or company over and over versus what you might make elsewhere. Remember that investment funds and companies often have a vested interest in keeping you in their shares, but it might not be the best idea for your own retirement savings plans.

Make sure your investment does not throw your allocations out of line. It might not seem like a big deal, especially if you are thinking about a dividend paying 1 per cent or 2 per cent on common shares. But if you are in a speculative high-yield bond fund that manages a 10 per cent yield and you are automatically reinvested, it could throw your portfolio out of whack in a hurry.

[Read: Understand the Science of Saving for the Future.]

Even reinvesting relatively small payouts can gradually nudge your allocations away from where you’d like them. “Over time, reinvesting dividends can push your portfolio out of balance compared to your target asset allocation,” Rodgers says.

Make the most of compound interest by staying invested. Reinvesting “keeps you from having a cash drag on your returns if you do not reinvest the cash dividend right away,” Rodgers says. The upside to automatically adding to your investments is that you’re saving no matter what. Behavioural finance studies show that by making your savings automatic, you are more likely to save than if you need to actively choose to do so. In a study published by the National Bureau of Economic Research, Harvard University researcher Brigitte Madrian found that the number of participants in workplace savings plans nearly doubled when people were “auto-enrolled,” compared to the number who did so if they needed to opt in to a plan. Dividend reinvesting applies the same principle.

While people investing in equities have often ignored dividends, they are worth paying attention to and can add up to big money over time. Rodgers notes that the S&P 500 index is up about 53 per cent over the past five years. If you followed a plan of reinvesting dividends on S&P shares, your return would be 71 per cent. So the upside is there if you are committed to owning stocks and can handle their associated risk, and if you don’t need dividends for other purposes like income.

“If the client is in the distribution phase of their life, I will most frequently recommend that they not be reinvested,” Balaban says. “I don’t believe introducing market risk into the equation is in the client’s best interests when I know the income is going to be withdrawn.”

This story was originally published by U.S. News & World Report.

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