Monday, February 18, 2008

An argument against reinvesting dividends

I do my own taxes partly to save money and, more importantly, for the chance to soberly review every transaction I made during the year. I have noticed something interesting that doesn't seem to be talked about much concerning the reinvestment of dividends.

To me reinvesting dividends only makes sense if the trading price of a stock at the time of the dividend is considerably less than its intrinsic value; that is, if reinvested dividends will be purchasing shares at a good price. If that's the case, why would I want to increase my holdings in a company the amount of a small dividend? If the stock is that much of a bargain, I'd rather pile in with new money.

If the price of a stock has risen to its intrinsic value or considerably above, why would I purchase more shares through a dividend if I wouldn't buy the shares with new money? In other words, why would I overpay for a stock through dividends just because I'm using "free" money?

Isn't it better to use dividends for better, newer ideas instead of potentially overpaying for old ideas?

Here's another aspect of reinvesting dividends that has irked me. Through my own folly I have bought stock, seen the prices rise, reinvested dividends, and then sold all the shares later for a loss, including shares bought with reinvested dividends. Shame on me for losing my capital through my own foolishness, double shame on me for paying too much for shares with reinvested dividends, and triple shame on me for losing my portion of the company's earnings through poor buying and selling decisions.

I would have been better served to have bought the shares I wanted, KEPT (!!) the profits of the company that were due me, used that money wisely, and also to have chosen a different stock!

Here's one more wrinkle: At the time of sale, shares that were purchased through dividend reinvestment in the last year of ownership will be taxed at the higher short term rate whereas older shares will be taxed at the lower long term capital gains rate. It could be a better use of your dividends to invest them in another long term investment. And it makes doing your taxes by hand a great deal easier.

I have learned these principles through the courses of hard knocks and I believe they are sound. Your thoughts?

I also resolve to do a better job of picking stocks :)

7 comments:

Dorian Wales said...

Hi,

Why are you still holding on to the stock if you're not willing to reinvest the dividends back in ?

Just wondering. Good luck blogging.

Dorian Wales
personalfinancier.blogspot.com

Oscar daGrouch said...

Perhaps this example will illustrate my point:

Let's say I compute the intrinsic value of XYZ stock to be $100. It is currently trading at $25, so I buy it. Later when it's time to receive a dividend, the stock sells for $90, or even $100. Now, at this point I could reinvest the dividend but it's not as good a deal as it once was.

At this time let's say I have found another stock, ABC, whose intrinsic value I compute to be $120 and it's trading at $30.

Even though I might still like XYZ, I would probably prefer to use the dividend to buy shares of ABC instead, since I would be getting more value for my money than by purchasing more shares of XYZ.

I might also not want to sell XYZ at this point since would trigger performance crushing taxes and since I might compute that its intrinsic value will increase at a satisfactory rate. I wouldn't buy more, but I would want to keep the shares I already have.

Oscar daGrouch said...

Perhaps this example will illustrate my point:

Let's say I compute the intrinsic value of XYZ stock to be $100. It is currently trading at $25, so I buy it. Later when it's time to receive a dividend, the stock sells for $90, or even $100. Now, at this point I could reinvest the dividend but it's not as good a deal as it once was.

At this time let's say I have found another stock, ABC, whose intrinsic value I compute to be $120 and it's trading at $30.

Even though I might still like XYZ, I would probably prefer to use the dividend to buy shares of ABC instead, since I would be getting more value for my money than by purchasing more shares of XYZ.

I might also not want to sell XYZ at this point since would trigger performance crushing taxes and since I might compute that its intrinsic value will increase at a satisfactory rate. I wouldn't buy more, but I would want to keep the shares I already have.

Anonymous said...

One reason for reinvesting dividends is if the dividend amount isn't large enough to buy something else without the tranaction costs being too high. Lets say you own 100 shares of a stock yielding .20 per quarter. That 20$ is hardly enough to buy any thing else, so it would sit in a money market until a suficient amount accumulates.

Lo. Price said...

I think it's great that you do your own taxes. It reminds me of the advice to buy with cash as often as possible because then you truly feel the impact of your purchase vs. just using plastic.
My personal philosophy is that it's best for most investors (and I include myself in this category) to stick with mutual funds, especially index mutual funds, and ETFs. For holders of these securities, vs. holders of individual stocks, you may agree that it makes sense for them to reinvest dividends (especially since they probably don't devote the time to other ways to use the dividend income). I also agree with Anon that relatively small dividend payouts don't lend themselves to investing in new securities (esp. when factoring transaction costs), but dividend reinvestment in most mutual funds is a much simpler proposition. Also, if you are concerned with tax implications of selling XYZ to buy ABC, perhaps you should focus your portfolio in a tax-sheltered account. Thanks for some good food for thought.

Asx dividend said...

I think preferred stocks are equity investments that also have characteristics of fixed-income securities.

asx ex dividend dates

Dividend said...

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