Saturday, October 15, 2016

Dividend Reinvestment for Millennials

It only took 5 years between my last post and the post before it, so a 6 month gap shouldn't be considered too bad! I hope to be able to post more in the coming weeks as time permits, but today I would like to focus on a very important topic that many millennial investors tend to ignore in favor of flashier strategies: income investing through dividend reinvestment.

While readers know I am a big advocate of index funds, I also think high dividend yield stocks can play an important role in millennials' investment portfolios, especially when the dividends are reinvested. I have covered the topic of dividend reinvestment before, but basically it means that whenever a company pays its quarterly dividend, those dividends will go towards purchasing more shares of stock in the company instead of being routed to your account's cash balance. The tax implications are exactly the same whether the dividend is paid out in cash, or if it's reinvested; most millennial investors will pay a 15% tax on qualified dividends. 

The reason income investing is enticing is that it can basically set an investor up for a large pot of passive income later in life. For example, if you buy 100 shares of Verizon Communications (VZ), you will receive $56.50 in dividend income every quarter ($0.565 quarterly dividend x 100 shares). As of 10/14/16, Verizon stock was trading at $50.28, so by reinvesting dividends, you are basically acquiring an additional share of stock every quarter - which in turn will earn more dividends - and this acts as an attractive source of compounding. The website buyupside features an easy to use dividend reinvestment calculator which helps to explain how dividend reinvestment increases long-term investment returns. As an example, assuming a 30 year investment horizon and 5% annual dividend and stock price growth rates, a $50 stock paying $2.00/year in dividends will result in 324.34 shares at the end of 30 years, and a total value of $70,088 versus $35,561 without reinvestment. This equates to a 30 year annualized return of 9.2% versus 6.76% without reinvestment. This is particularly beneficial later in life, because once an investor hits retirement, he or she can stop reinvestment and allow the dividends to be paid in cash to be used for whatever the heart desires. 

For investors who tend to shy away from individual stocks, the same benefits can be had by reinvesting the dividends paid by your mutual funds. Most bond funds distribute interest payments monthly, and most actively and passively managed funds pay distributions quarterly. 

A word of caution, however. Not all high dividend yield stocks are created equal. Many are master limited partnerships (MLP) which have run into trouble lately, others are companies with high yields due to poor financial position (yield goes up as a stock price goes down provided the dividend isn't cut), and some simply don't generate enough free cash flow to fund the dividend. Companies with strong free cash flow and payout ratios (dividend per share/earnings per share) in the 0.50 range may be attractive income investment candidates. Never purchase a stock on yield alone without doing more research into the sustainability of the dividend. It's important to consider the long-term dividend payout track record, as well as the cyclicality of the industry the company is in, among other factors.

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