If you own shares in a company that pays cash dividends, you receive a portion of its profits periodically.
When that time comes, you’ll face a decision: should you pocket that cash, or put it back to work by reinvesting it? In this article, you’ll learn all about your options so you can make a confident decision.
Understanding dividend basics
To start, here’s a quick recap. A dividend is a payment a company makes to its shareholders in the form of cash or more stocks.
Companies listed on a stock exchange – through their board of directors – decide how much of their net profits will be issued for dividends and when they’ll do so.
Note that dividends from stocks aren’t guaranteed since companies may decide to cut, pause, or stop dividend payments.
Real Estate Investment Trusts (REITs) are an exception. These corporations are required by law to pay back 90% of their distributable earnings to investors through dividends.
Ways to reinvest your cash dividends
If you choose to reinvest, you're essentially using your dividend earnings to invest more rather than spending the cash on goods or services. Here are your main options:
Option 1: Buy more of the same shares
This is the most straightforward reinvestment approach. You take the dividend you just received and use it to buy additional shares of the same stock.
When you own more shares, you may be entitled to larger dividends in the future. This means you have the potential to benefit from compound growth as your dividends earn dividends over time.
Option 2: Purchase other stocks
Instead of buying more of the same stock, you use your dividend income to buy shares of a different company.
This approach lets you diversify your portfolio, which simply means spreading your money across different investments so you're not overly concentrated on just 1 or a few companies.
Option 3: Invest in other assets
Another way to diversify is to have a mix of different assets. To do so, you can put your cash dividends in other types of investments like bonds, pooled funds, and deposit products.
With the right asset allocation, you can mitigate risk by having investments that tend to behave differently under similar market conditions.
Reinvest or take the cash? What to consider
So, which option is best for you? Since investing is personal, your unique situation matters when making a choice.
Here are a few questions to ask yourself:
1. What stage of life are you in?
If you're young and won't need the money anytime soon, reinvesting makes a lot of sense. Time is a huge advantage because the longer your earnings compound, the bigger your money may grow.
If you're nearing retirement or already relying on investment income to cover living expenses, taking the cash may be the more appropriate choice.
2. What are your financial goals?
Are you investing long-term for wealth? Or are you investing to have additional income streams for current needs?
Long-term investors generally benefit more from reinvesting. Those who need income currently — to cover regular expenses or have extra money for wants — may prefer to take the cash.
3. Is the stock worth owning more of?
Before putting more money into the same stock, find out if the company is still worth investing in based on its financial health and growth prospects.
You can also check its dividend payment history and how well it fits in your overall portfolio to know if the stock still offers value or if it’s time to redirect those dividends elsewhere.
4. What does your portfolio need?
Stocks tend to go up and down in value more quickly than less-volatile assets like bonds. That’s why they’re generally recommended for investors with a high risk tolerance.
If you’ll reinvest in the same shares or similar stocks, you’ll likely end up with more high-risk assets in your portfolio. Additionally, your investments may become more concentrated in certain industries.
To maintain a well-balanced portfolio when reinvesting, check your diversification needs and find out whether if it’s ideal for you to put more money in high-, medium-, or low-risk assets, and which specific types to consider.
It can also be wise to keep cash in your portfolio so you can act on investing opportunities when needed.
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