One of the great things about dividend stocks is the regular stream of cash that income investments provide. While some investors choose to reinvest the dividend, others prefer to take the cash. Which is right?
In the Dividend Stock Hour that aired on Fool Live on Oct. 29, Fool.com contributors Danny Vena and Jason Hall discuss why a one-size-fits-all methodology may not be the right approach.
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Jason Hall: Rafael asks, "Is it better to reinvest your dividends or keep it?" Danny.
Danny Vena: I really love this question. The reason that I like the question is because the answer is not the same for everybody. You know, it really depends on your individual situation. If you are somebody who is younger and who is adding to these dividends, stocks, and looking to create an income stream for later, I think it makes a lot of sense to reinvest the dividends because it becomes that compounding machine that we referred to earlier. You end up buying more shares of the stock at various price points. So when the price is higher, you get fewer shares, when the price is lower you get more shares. Over time, you are consistently adding to that position. What that does over time is that really supercharges the amount of dividends that you're going to get out of that in the future.
Now, by the same token, if you have already reached a point in your investing career where you want to take that income and use it -- and you can want to use it for various reasons. Maybe you are not adding to your portfolio as much as you once did. But you see some opportunities out in the market that you want to capitalize on. There's some other stocks out there you want to buy and you don't have the income to do it. That would be one reason to actually take your dividends in cash so that you can use that money. Another reason would be if you're using your dividends to subsidize your living, then you might want to take those in cash. It's a really great question. It really depends on where you are in your investing life as to how you want to answer that question for yourself.
Hall: Yeah. To follow onto that, to try to put it in one sentence, I think the farther you are from your financial goal, the more it probably makes sense to reinvest the dividends. As you get closer to those financial goals, putting your kid through college, buying a vacation home, paying for retirement, a couple of things happen. Number one, you start to have a very specific allocation for that cash that you can consider beyond just reinvesting it. Number two, your portfolio has gotten larger. When you're just getting started and you're building up your portfolio and you don't own a ton of dividend stocks, the amount of cash that they kick off might not be meaningful enough to allocate appropriately. That's one of the challenges that you might run into.
I've talked about over the past week that I've tried to get to five percent of my portfolio in cash as a hedge against stupidity. It's money that I can use to do something like when there's market sell-offs. It gives me some extra cash above and beyond my regular monthly contributions. It gives me that extra cash that I can use to take advantage of market opportunities. I know a lot of people that are already retired, don't really have cash and they are mostly invested. This might be a good opportunity for you to not reinvest those dividends so that that extra cash that it kicks off gives you money to work with when we do have a market downturn you want to buy.