The Easy But Somewhat Unsatisfactory Method
Not too many years ago, it was too costly to take your dividends in cash and then decide what investments to buy. The cost of the individual transactions made it prudent, most of the time, to turn on “automatic dividend reinvestment.” This ensured that you were making the growth engine work in your favor. The potential downside was that you might be buying more of an existing investment that had some characteristics you should think about before buying more.
For one, the original investment might have been purchased at a very good price, and now the price for the ETF or stock shares might be inflated. Secondly, the investment itself might no longer be the best choice for the future. It also might be that you already have enough shares, especially if you are investing in individual stocks. Finally, when things are running on autopilot, it means the pilot might be forgetful to see if the flight path needs to change. It might be easy to reinvest automatically, but it might not be prudent.
The Better Approach
You are probably wondering, “what does Wayne do, and how does he do it?” Some of my reasons for my approach are tied to the reality that next year I will have to take RMD’s from my traditional IRA. I suspect most of you don’t face that reality, but there are some things to learn from my approach, nevertheless.
I turned off automatic dividend reinvestment when trading costs became $0. There are five reasons for this. They are price, diversification, RMD’s, ETFs and disciplined thought.
- I want to decide which ETF and stock position(s) to buy. But I also want to buy at my price, not on the dividend date price. I rarely buy at the market price. I set buy limit orders to invest at least 95% of the time.
- I may want to start a new position that I believe is undervalued. Because I keep very little cash, I like having cash flowing into the hopper for buys. In other words, I might want to increase my diversification.
- I will have to start RMD’s next year. I don’t want to have to think about cash flow and I don’t want to sell existing positions just to satisfy the RMD requirements. It is rarely wise to be in a position where selling a position is your best option to raise cash. You don’t know when the market will be down or up.
- Because I am primarily in individual stocks but am gradually adding to my pool of dividend growth ETFs, I want to add to those ETFs.
- It forces me to think. It doesn’t take much time, and it is a prudent way to invest. Autopilot works until it doesn’t.
Do You Know How To Make Changes?
It is easy to turn off or turn on automatic dividend reinvestment on the Fidelity Investments website. Here are a couple of screenshots to get you started. One word of caution: If you make changes on Monday, and the stock’s or ETF’s ex-dividend date is just around the corner, you will probably see the dividend reinvested. However, the next month or quarter it will do what you told it to do.
What Other Investors Are Doing
One Fidelity Investments investor asked this question recently: “I have always held to the philosophy of re-investing dividends. But in this era of broad-based declining values, is this still the prudent approach? Am I better off taking the cash and picking my spots to use it?”
Some of the responses included:
- “We love dividend reinvesting but we are sticklers when it comes to valuation. We reinvest the dividends for companies that are valued too low or fairly valued. If they fall in the overvaluation category, we move that dividend to cash. This is typically performed on our taxable brokerage accounts as the IRAs and Roth show the dividend as zero cost basis, which is very appealing. For those accounts, we typically reinvest.”
- “We are now using our dividend income stream for our retirement. Prior to that, all dividends were reinvested, but not necessarily into the originating stock. Instead, we used the dividends to further diversify our portfolio or for rebalancing.”
- “I am also a dividend re-investor. I stick with it. Because if I don’t, I will likely do a worse job trying to figure out how to use that cash to make money. And it saves me time. I am in it for the long haul. New if I were retired, I might turn off some of the reinvestments and use the cash to pay my bills. But until then, I reinvest it.”