One of the attractions of owning shares is that I may receive dividends from them. But what should I do with these payments – spend them, or use them to buy more shares? Here I explain why I prefer to reinvest dividends.
Dividends as passive income
One approach to using dividends is simply to treat them as a source of passive income.
For example, at the moment a number of large companies offer a dividend yield of 8% or more, including Direct Line, Imperial Brands, M&G, Persimmon, and Rio Tinto. If I invested a £20,000 Stocks and Shares ISA evenly across those five shares, I would hopefully receive dividend income next year of £1,825. That could give me passive income of £35 a week if the companies maintain their dividends (which is never guaranteed).
On top of that, I would own the shares. So if I simply kept them and did not invest any more money, hopefully I would keep getting £35 a week in passive income for the foreseeable future, long beyond next year.
I could reinvest dividends
Another option open to me would be to reinvest dividends I earn.
I might do this in a couple of ways. One would be to reinvest dividends in shares of the company that paid them to me. So, for example, if I get a dividend from 10.4% yielding Persimmon, I could reinvest it and boost my holding of the builder’s shares by over a tenth. That should hopefully increase my dividends the following year, if Persimmon keeps paying out at the same level. Many companies offer a form of dividend reinvestment plan, so if I did this I may find I could buy shares for lower dealing fees than I would otherwise pay.
A second option would be to keep the dividends but not necessarily reinvest them in the shares that paid them to me. What would be the advantage of such an approach? One is that a share could shoot up in price. So just because it offers me an attractive yield today, buying it a year from now with my dividends may not offer me the same value.
Buy, sell, or hold?
Also, I may earn dividends from shares I am happy to hold but do not want to keep buying.
For example, the Imperial yield is appealing to me. But like all companies, Imperial faces risks to its business. A decline in smoking could hurt profits and lead Imperial to cut its dividend, as it did a couple of years ago.
So I may decide that although I am happy to own a company, I think the long-term prospects of other businesses are better so do not want to buy more of its shares. That is not perfectly logical – if I reckon a company’s prospects are bad and do not want to add more to my portfolio, arguably it makes sense for me to sell what I already own. But that depends on my own risk profile. Sometimes, I may be comfortable owning a share but not want to increase the percentage of my portfolio I allocate to it.
As an investor, my goal is to increase my wealth. If I reinvest dividends instead of spending them, I can hopefully do that faster.