1. Money

Reinvesting Your Dividends vs. Not Reinvesting Your Dividends

The Dividend Dilemma Every New Investor Must Face

By

Reinvesting Dividends Versus Not Reinvesting Dividends

Whether you reinvest your dividends or not will have a large influence on your ultimate net worth, as well as the amount of cash you get to spend during your lifetime. There is no right or wrong answer; it is about what is best for your family.

Image Copyright © Kennon Green Press, LLC. All Rights Reserved.

One of the most important questions you will face as a new investor is whether you should spend the dividends you receive from your stocks each year, or whether you should reinvest them for future growth.  The choice you make will have an enormous influence on your ultimate net worth, as well as how much enjoyment you get out of your capital along the way.  

To help you understand the trade-offs better, I thought it might help to look at a real-life example of a successful company.  By focusing on the actual implications of this decision, you might be better equipped to decide which approach will work for the portfolio you put together to help your family reach its financial goals.

An Investment In Coca-Cola Over the Past 50 Years Without Dividends Reinvested

Last month, I wrote a post on my personal blog looking at the return an investor could have earned over the past 50 years had they put $10,000 into shares of The Coca-Cola Company in mid-June of 1962.  The period examined covered exactly half a century, or one investing lifetime.  Following a question about the effects of dividend reinvestment on the ultimate returns, I re-ran the numbers (you can find the methodology and notes in this post).

My research showed that you would have been able to acquire 131 shares of Coke stock at $76.50 per share in 1962.  In June of 2012, you would own 6,288 shares as a result of stock splits, trading at $77.44 per share, or $486,943 for the entire position.  Along the way, you would have cashed dividend checks for $136,271.  Thus, your $10,000 turned into $613,214. 

The good news?  Your results are far better than they appear because the dividends would have provided far more purchasing power.  Consider that $1 in dividend income back in 1962 would buy far more than $1 in dividend income today.  For example, for the full year 1963, you would have collected $353.64 in cash dividends.  That is the equivalent of $2,652.04 after adjusting for inflation.  

To put the performance in perspective: Even after dividend taxes, assuming you had a typical family of two parents and two or three children, the Coca-Cola dividend income would have provided enough cash to take an extended vacation at Walt Disney World every three years, paid for out of pocket.  In the five decades you held the stock, you would have enjoyed 16 or 17 family vacations, courtesy of your Coke dividends.  On top of that, you would wake up to find $486,943 in Coca-Cola shares sitting in your brokerage account, which generate $12,827.52 in annual cash dividends that are mailed to you each year. 

That isn’t bad for never having to do a single day of work after making the initial investment back in 1962!  One good decision with $10,000 and you earned 16 or 17 amazing family vacations, have nearly $500,000 sitting in an account, and receive checks for nearly $13,000 per year before taxes, all without having ever touched the original 131 shares of Coca-Cola.  That is an investment success story.  It is a testament to how powerful compounding can be when you own high quality assets.  (We are just talking about a stalwart blue chip like Coke.  Imagine if you had invested in a successful startup like Microsoft, Apple, Home Depot, Wal-Mart Stores, Cisco Systems, Dell, or Southwest Airlines.  You’d have millions, if not tens of millions, of dollars.) 

An Investment In Coca-Cola Over the Past 50 Years With Dividends Reinvested

The question remains: What if you had reinvested those dividends?  What if you had foregone the enjoyment of a family vacation every three years and, instead, increased your equity holdings in the business?  To answer that question, I broke out a fresh spreadsheet in my home study this weekend and looked at 50 years of dividend and stock price data for The Coca-Cola Company.  

The answer: Your 131 shares of Coke, bought in 1962, would have grown into an estimated 21,858 shares by 2012.  The market value would be between $1,700,000 and $1,800,000, and your annual cash dividends would be more than $42,000.  All of that wealth flowed from a single $10,000 seed planted back during the time John F. Kennedy was in the White House.

Which Is The Right Choice: To Reinvest Dividends or Not?

Would you have rather enjoyed $136,000+ in cash along the journey, and taken 16 or 17 vacations with your family, or would you rather have an extra $1,100,000 or so today, along with the $30,000 in extra annual cash dividend income that comes with it?

I hate to be the one to break it to you, but there is no “right” or “correct” answer.  Whether you reinvest the cash or not depends upon your situation, your goals, your objectives, your personality, and your need for funds.  For a young, successful lawyer or accountant with plenty of income who could afford whatever his family needed, reinvesting the dividends might have made perfect sense.  Today, as a retiree, he would be glad he made that election as he counted the $42,000 in cash that flowed through the door every year courtesy of the Atlanta-based soft drink giant.  On the other hand, a young, struggling teacher who invested an inheritance would have probably been far better off using the cash for enjoyment throughout her lifetime because the utility of those family trips would far exceed the utility of the extra wealth today.  She still ended up with roughly $500,000 in her brokerage account and $12,000 in annual income from her dividends.  Why complain?  That's a great result.

I reinforce this point constantly in my personal writings, but it is worth repeating here: Your goal is not to die with the highest net worth possible.  Your goal is to die having used money as a tool so that it gave you the most enjoyment and security you could possibly have expected.  Bottom line?  Whether you reinvest your dividends or spend them, don’t be upset about it.  Think it through rationally and be content with whichever path you choose.  Your investment portfolio is there to serve you.  Never forget that.

Reinvested Dividends Can Help Make Up Market Losses Faster

The research of professor Jeremy Siegel on stock market returns has illustrated that reinvesting your dividends during a market crash can result in recovering your total net worth much faster than you otherwise could. I wrote about his findings in an article called The Secret to Recovering Stock Market Losses.

©2014 About.com. All rights reserved.