Reinvested dividends happen when an investor chooses to put income from an investment back into the same investment.
This can be done manually but often it’s an automatic process. The goal is to simplify the investment process by using dividend income to immediately buy more of the investment.
Reinvested dividends can be done with a single stock, a stock mutual fund, an index fund — any publicly traded investment that offers regular income.
To better understand reinvested dividends, let’s break down the source of the income itself.
Companies are in business to make a profit. In some cases, that profit is reinvested into the company’s operations.
The idea is that a growing business that needs financing is better off self-financing. If not for cash from profits the firm might need to borrow money to grow.
Some companies, however, have grown as much as they are likely to grow and have no logical place to put their profits.
In those cases, a dividend is issued by the board.
Normally, shareholders have a claim on some portion of that profit, which is typically issued quarterly. As a result, dividends are expressed in cents per share.
For instance, a 10-cent dividend would pay a dime for every share you own. If you own 1,000 shares, that’s $100. Multiply by four quarters and you have $400 a year of dividend income.
Investment professionals often talk about “total return” from a stock or stock mutual fund. Total return is the change in price of the investment, or appreciation, plus the income from dividends.
You might want or need the dividend income from your stock holdings. But many investors instead prefer to “drip” that income back into the investment.
Many companies will do this automatically for shareholders and even purchase fractions of shares in order to soak up every cent of the reinvestment. It’s important to note, however, that dividends can be reduced or eliminated by a company’s board and they are not guaranteed in perpetuity.
If you own mutual funds or index funds, your brokerage can reinvest dividends automatically as well. They purchase shares and fractions of shares to account for every penny.
Of course, as the investment grows, reinvested dividends increase the total number of shares, setting off a virtuous circle of generating even more income in the next quarter and so on.
If you reinvest dividends in a taxable account, know that you will be taxed on the dividend income, despite not taking it out to spend. It is income, after all.
Reinvested dividends can be a powerful way to supercharge your long-term investment plan.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.