So, you’ve just got your quarterly dividends, so now what? Maybe go out and buy something new? Sweep it over to your bank account to put into your targeted savings fund? Or maybe just use it for day to day living expenses. Well, you could, but you’d be better off re-investing those dividends back into the stock, index fund, or mutual fund that paid it out.
Whether you’re an old hand in the stock market or you’ve just bought your first few shares in an index fund, you need to understand where stock market gains come from, dividend reinvestment, fractional shares, and dollar cost averaging.
Stock Market Returns
As I discussed in our primer on investing, there are two sources of market returns – capital gains and dividends. Capital gains are the returns you get from the appreciation in the value of a stock. You lock in your capital gains when you sell. For example, you buy a stock for $100, then you sell it for $110 a year later. That means you made $10 in capital gains on your share of that stock.
The other source of gains you get from stocks are dividends. Dividends are cash that is returned from the company to its shareholders – i.e., it is paying out a portion of its profits to you, the owner. Dividends are most often paid quarterly (four times a year). For example, let’s say you bought a stock for $100 and it pays a $2.00/share dividend that is paid quarterly. This means that every quarter (every 3 months) you’ll receive $0.50 for each share that you own. So, if you own 1000 shares then you’ll receive $500 per quarter.
Although it is easy to focus only on the capital gains because the stock price is the headline number, a substantial amount of the long-term gains you will make in the stock market come from dividends… and if we want to really benefit from the miracle of compound interest you need to re-invest your dividends back into that stock, so next time you’ll be getting interest on more shares, and so-on.
I know what you’re thinking right now, which is that I don’t own 1000 shares… I only own 10 shares, which means my dividend this quarter is only $5, which isn’t enough to buy a share. That is true, you can’t buy a share. However, most modern brokerages offer you the chance to re-invest dividends regardless of the amount and will issue you a “fractional share”. So, what does this mean in practice?
Let’s work through an example. Let’s say you own 10 shares of XYZ, which is trading at $100/share and pays out a $0.50/quarter dividend. This means you receive $5 in total. If you select to have your dividends re-invested, your dividends will be used to be 0.05 shares, so you’ll now own 10.05 shares. This means next quarter you’ll receive a dividend on 10.05 shares ($5.025). You can then re-invest that you’ll then own 10.10025 shares. Continue this for years and it can add up quite quickly.
You’ll notice that I didn’t mention the commissions. This is because most brokerages like TD Ameritrade and Schwab will do dividend re-investments for free. This makes it the cheapest way to buy stocks available from most brokerages.
Fractional shares, are quite simply, just small pieces of a share of stock. You can sell it the same way you would a whole share and you are entitled to the portion of the dividend that the stock pays out. The primary difference is that you don’t normally get the voting rights that come with that stock because there isn’t a good way for those to be divided out amongst all the holders of that fractional share of stock.
Dollar Cost Averaging
The other benefit of dividend re-investment is that it helps to average out your cost basis through time. Since your dividend re-investments will be at regular intervals you will sometimes be buying at high prices and sometimes at low prices, meaning that through time you won’t have a cost-basis for your stock that is at the peak. This is important because retail investors often buy into the market late in the cycle, meaning that they normally buy at the top of the market.
Unless you are in retirement and living off of your dividends, or are using them for a specific purpose like buffing up your Emergency Savings Fund, you’re better off re-investing them into the stock or fund that paid them, so you can grow your position through time, accelerating your path towards FIRE.
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