Why Dividend Reinvestment Can Be Important to Your Financial Plan
As a CERTIFIED FINANCIAL PLANNERTM and financial coach, I'm all too familiar with how terrifying it can initially be to begin investing money. This is money that you've spent months or even years saving, and now you're giving it up to possibly never see again. When it comes to investing, the best thing you can do is educate yourself. You may not want to invest your money personally. You may wish to have someone, like me, to mitigate risk and help you along with the scarier parts of investing.
Though it can initially be a huge hassle to invest, buying into stock and mutual funds can also be incredibly rewarding. I'm always excited when I talk to my clients about how well their investments have performed. When you get to the point when your money is making more money, it leads to a problem. What do you do with that money? How can that money be best utilized, and how should you allocate it? These are common questions I get from clients. Some stocks and mutual funds often pay dividends either monthly, quarterly or annually. What you do with those dividends is essential to your financial plan.
Getting dividends on your stock and mutual funds is fantastic. You're feeling on top of the world with all of your earnings, but then questions arise, "What do I do with these?" Well, you have options when it comes to how you're going to handle them. There are three things people commonly do with dividends, some of them are generally better strategies than others, but that depends on your financial goals and situation.
You can take the cash. Push a button, get a reward. This is the first and most enticing option of what you can do with your dividends. Taking the money from your dividends is one of those immediate gratifications that are hard to come by. While it seems like a no-brainer, and you should take the cash, it isn't that simple. What you're missing out on if you take that money and spend it is the potential of what it could be down the road. (Read my blog post "How Saving and Compound Interest Helps Your Financial Plan.)
Invest your dividends. Investing your dividends is your second option. Depending on your situation, it's usually a middle-of-the-road solution. With this option, you take the cash and combine it with other funds/cash to invest more money in different companies. One pro to this is diversification. According to Investopedia, "Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio."
This leads us to the third and probably the best option of what you can do with your dividends, reinvesting. What is dividend reinvestment? Well, it's the principle of purchasing more (sometimes fractional) shares with your received dividends. Companies like it when investors reinvest, so they make it easy for you with DRIPs or dividend reinvestment plans. A DRIP is a plan that investors can sign up for, automatically reinvesting your dividends at the going market rate.
Why Would You Reinvest Your Dividends?
Well, simply put… compounding interest/compounding growth is the main reason one would use a reinvesting strategy. Though compounding interest and compounding growth are different, they use the same principle. According to The Motley Fool, "Compounding interest is essentially interest on top of interest. With compounding in the example above, not only will your account balance grow every year, but the amount by which it grows will also grow each year."
Think of it like this, the base amount of money you invest gets a return based on a percentage. If you're investing $100 at a theoretical 10% interest, you'll get ten dollars of interest. If you reinvest, the next year, you're investing $110, so the amount you'll be paid back will be higher. If you follow that trend, you're looking at a higher and faster growth rate than you would be if you were taking the ten dollars and investing $100 again the next year. Basically, if you aren't reinvesting in a dividend paying stock/mutual fund, you're leaving your money's potential growth on the table.
Stay tuned for next week's blog post that explains how dividend reinvesting works hand and hand with Dollar Cost Averaging! (Exciting... I know!)
Why Would You Not Reinvest Your Dividends?
While it makes sense in theory to reinvest, life happens. As a financial planner and coach, I listen to people daily. I understand that life events happen and can occasionally get in the way of our financial plan. That being said, there are a few reasons reinvesting your dividends, primarily through a DRIP-style automated program, may not make the most sense.
As an example, sometimes bills and expenses can overtake us. If you need the money, you need the money, and it's a better alternative to a payday loan or credit card debt. In that situation, you need to do what will harm you the least, and taking cash from your dividends may make the most sense. Other than that, if for whatever reason you don't want to reinvest in that particular stock or fund, you may want to begin pulling your money to allocate somewhere else.
In the case of retired individuals, we often plan to live of the dividends and income that an investment portfolio produces. The underlying objective is to not dip into the principal you have diligently saved for retirement. Instead, as a part of a comprehensive financial plan, we choose not to reinvest certain dividends produced by investments..
You should also consult your tax advisor or CPA to ask if there is any reason that dividend reinvestment would be a taxable issue for you!
No matter what the reason is, that would keep you from reinvesting your dividends, make sure you're keeping an open and honest dialog with your financial planner and those who are affected by your financial decisions. The last thing you want is for the person managing your money to find themselves in a scramble or for your loved ones to be caught off-guard.
A CERTIFIED FINANCIAL PLANNER™ Can Create a Comprehensive Financial Plan That Includes Dividends
Creating a financial plan means that you'll have a clear picture of your money and where it's going. Planning is critical, and having your financial plan work for you instead of working for it will keep you a happy camper! Ensure that you're working with your financial advisor representative or financial planner to have reinvesting on your radar. If it is, you shouldn't come into a situation that forces you to take the cash instead of reinvesting. Reinvesting your money is a long-term game, which means you don't want to have to pull your money out at the drop of a hat. That will affect your financial gains over time.
Do you want to make a financial plan that incorporates reinvesting dividends? If you need help figuring out where to start when investing or reinvesting, please call or email to schedule an appointment with me. I'll work with you to create a financial plan that's optimized for you.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox CERTIFIED FINANCIAL PLANNER™ is also a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.