I can't lie: I'm not immune to the short squeeze madness or the cryptomania or the Reddit-fueled assault on Robinhood. It's very easy to be caught in the news, questioning your long-term plan and wondering whether your commitment to index funds is entirely misguided.
These moments, while exciting, are also great opportunities to remind yourself of the basics when it comes to long-term investing. One of the core tenets surrounding good financial planning is to maintain a long-term focus, one in which dividend reinvestment is the key to unlocking an effortless compounding effect. In this article, we'll look at a chart that shows what dividend reinvestment is and how it can change your life.
Image source: Getty Images.
What is dividend reinvestment?
Dividend reinvestment is an account feature that causes all dividends paid by your investment holdings to be automatically reinvested into the holding that produced it. For example, if you own 100 shares of Johnson & Johnson (JNJ +0.51%) stock, you'll receive a quarterly dividend of $1.01 per share. You have the choice of receiving that dividend in cash, which could be paid directly to your bank account. Alternatively, you have the option to reinvest the dividend.
When you reinvest dividends, you will not take the dividend in cash, and instead your account will automatically purchase additional shares of JNJ stock. In that scenario, you would now own more shares of JNJ. This has the effect of causing future dividends to be higher, which will also be reinvested to buy even more shares. This iterative process is known as compounding, and will allow your investments to grow relentlessly over extended time periods.
As the above chart depicts, had you held an S&P 500 index fund since 1990, you'd end up significantly better off if you had reinvested dividends than if you took the dividends in cash. The orange line above represents the fund's total return, which is the fund's price return plus its dividend yield. The purple line simply represents the fund's increase in price over the last 30 years without dividends accounted. The lesson here, if you take nothing else away, is that having your dividends automatically reinvested is likely to substantially increase your returns over time with absolutely no added effort or analysis.
Other effects of dividend reinvestment
- If you hold your investments for over one year, your future dividends will likely be qualified dividends (some investments, like REITs, that rarely qualify for this treatment). Qualified dividends are also taxed at a lower rate than ordinary dividends. Much the same as investment returns, these tax benefits will compound over time as dividends are continuously redeployed.
- Dividend reinvestment keeps you perpetually invested. As has been said before, it's "time in the market" that matters, and no time is wasted if your dividends are immediately sent back to the market once you're entitled to them. Unless you need the cash or plan to deploy it in a different investment soon, keeping dividends in your settlement account is not ideal.
- It helps encourage a hands-off approach to investing. We've explored before that more trading is often associated with higher taxes, higher commissions, and lower long-term returns. Setting dividends to reinvest is an easy way to seamlessly adhere to core financial planning principles that will bear fruit over long periods of time.
Short-term trading is tempting
It's completely understandable that many people want to buy and hold GameStop (GME 2.04%) for reasons other than and in addition to making a return. Money can certainly be made by playing short-term movements in the market, and it has been done. But money can also be lost -- and a lot of it.
As volatile markets almost definitely lie ahead, you may want to consider revisiting some of the basic investment principles that have proven to lead to sustainable returns over time. That includes dividend reinvestment and the huge gains it can produce over time.
