The Best Way To Reinvest Your Dividends For Retirement

Reinvesting your dividends received from high-quality dividend growth stocks is a great, relatively conservative and proven way to build wealth over the long term.  This is especially true and appropriate for investors in the accumulation phase that are planning for future retirement.  Accumulating additional shares of dividend growth stocks can, and will, provide an increasing and eventually larger stream of income available at retirement when income is needed most.

There are two primary strategies that can be implemented to reinvest the dividends provided from a portfolio of dividend growth stocks. First of all, most high-quality dividend growth stocks investors have the option of enrolling in formal company dividend reinvestment programs, also known as DRIP plans.

When the investor formally enrolls in a dividend reinvestment plan, they will no longer directly receive their dividends in cash.  Instead, the dividends will be automatically used to purchase additional shares of stock in the company.  Also, if the company you own does not have a formal DRIP plan, many brokerage houses offer their own plans that will allow you to reinvest your dividends directly back into the company.

The second strategy for investors interested in investing their dividends is informally known as “collect and invest.”  With this strategy, the investor allows their dividends to accumulate and then personally picks and chooses which companies they will add this fresh and received dividend capital to.  The central idea behind this strategy is to avoid reinvesting dividends into high-priced or overvalued stocks and opting instead to reinvest accumulated dividends only into low-priced or undervalued stocks.

Which strategy is the best way to reinvest dividends?

One of the most commonly asked questions I receive from dividend growth investors is which or what is the best way to reinvest their dividends.  The following is a classic example of this question that I was recently asked:

“Reinvesting Dividends?  Currently for both my taxable and IRA accounts I reinvest all my dividends automatically back into those companies every quarter. Is this the best approach or should I reinvest these funds in stocks that are currently “fair valued” every quarter?”

In my personal opinion, both strategies are viable and attractive. Moreover, there are advantages and disadvantages to both. Automatically reinvesting dividends each quarter takes advantage of the underlying and proven principal of dollar cost averaging – but with a slight twist.  I will elaborate more on the twist I’m referring to later in the article.  The primary benefit of this principle is that it takes all decision-making, thought and emotion out of the equation.

If the price of the stock you are automatically reinvesting in is high (overvalued or expensive), your dividends automatically buy fewer shares. If the price of the stock you are automatically reinvesting in is low (undervalued or cheap), your dividends automatically buy more shares. Consequently, your money is in essence being more aggressive when prices are low and more conservative when they are high. In the long run, your average price will balance or average itself out. I am a big believer in dollar cost averaging; in over my almost 50 years in finance, I have seen it work quite well many times.

On the other hand, collecting dividends each quarter and then reinvesting them only in stocks that you feel are currently fairly valued is also a great strategy. In theory, you would be more likely to be making sound and more profitable investments with each dollar available. However, both judgment and time are required.

In other words, collecting dividends and then allocating them only to the stocks you feel are appropriate is both more research-intensive and time-consuming.  Furthermore, both judgment and emotion are involved. Personally, this is the approach that I prefer and utilize. However, I am a professional that analyzes investments all day – every day. Therefore, I have the time, experience, and with all due humility, the knowledge to most effectively reinvest the dividends I gather into what I consider the best valued choices available at the time.

Consequently, I do not think either option is right or wrong.  Moreover, I do not consider either option necessarily better or worse than the other.  The best choice ultimately comes down to the one that each individual investor is most comfortable with and capable of executing. In the long run, I have seen both approaches succeed.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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