To many investors, it's common sense to reinvest dividends. I myself have advocated doing so, many times. There are plenty of good reasons for this. Consider the words of syndicated financial columnist Scott Burns, for example. He recently wrote: " . dividends play a much larger role in long-term returns than most investors think. According to the Ibbotson Associates yearbook on asset returns, capital appreciation contributed much of the 10.4% annualized compound rate of return on large common stocks from 1926 through 2004. But nearly half came from dividends and their reinvestment." Burns added that, "Another benefit is that it is a form of dollar-cost averaging. Your dividends will buy more shares when the stock price is down than when it is up."

Good points, all. There are some other aspects of this issue worth considering, though -- it's not all quite as simple as I (and others) have made it out to be. Reinvesting dividends is often a smart and effective thing to do -- but you might have smarter and more effective options.

Why reinvest?
Viewing the matter very simplistically and traditionally, you would reinvest your dividends in the stock of the company that paid you the dividend. If you buy shares of Altria (NYSE:MO) and enjoy a 4% dividend yield on your $3,000 investment, you'll receive around $120 per year in dividends. You'll have that reinvested, buying (at current rates) about 1.6 additional shares. (Many dividend reinvestment plans permit the buying of partial shares.) If you have $5,000 plunked in Motley Fool Inside Value pick Pfizer (NYSE:PFE) and are getting 3.5% on it in dividends, that's $175, which is worth more than eight additional shares.

These dividend sums may seem like small amounts. If you're used to plunking $3,000 or $5,000 at a time into a company, what's $175? It could buy you a modest digital camera or an outfit for work, but what would it do for you as an investment? Well, think of it this way -- if Pfizer grows at 8% per year for the next 20 years, your $175 will end up worth more than $800. Plus, each year you'll get another $175 -- or more, since companies tend to increase their dividends over time. Plus, each year those new shares will generate dividends of their own, purchasing even more shares. See the magic? Reinvesting dividends can really turbocharge the returns you get from an investment

Where to reinvest?
Here's the point I hadn't thought about sufficiently before: Instead of automatically looking to reinvest your dividends into the stock of the company that issued them, step back and ask yourself where your confidence is greatest. In the universe of stocks out there, for example, would Altria and Pfizer be among your top choices? If so, then by all means reinvest those dividends in extra shares of Altria and Pfizer. But if not .

Should you see more promising investments, it makes sense to take that dividend money and plunk it into your best ideas. You might need to pool all your dividend income from various holdings together so that you have enough to make a meaningful investment while paying a reasonable commission. For example, your $120 and $175 total $295. If you have another $250 in dividends from other holdings, that would total $545. Paying an $11 commission to Ameritrade (NASDAQ:AMTD), for example, would amount to a reasonable 2% of the value of the trade.

Note that of course, you can augment your dividend sums with additional investment funds. That's a good idea, in fact. And if you just don't know what your best investment ideas are, consider opting for a simple index fund, or perhaps an exchange-traded fund (ETF) that tracks the broad market, such as the Spider (AMEX:SPY). (Learn more about ETFs in our ETF Center.)

One caution for this approach is that eventually, you may end up with just too many holdings. If you keep adding new ones, be prepared to reevaluate your holdings and pare them down now and then.

One more important angle to consider is this: If you don't have enough faith in Altria or Pfizer (or whichever dividend payers are lurking in your portfolio) to reinvest your dividends in additional shares, then take a few minutes to ask yourself whether you should be holding any of their shares. Maybe, just maybe, it's time to sell them. (Remember, these are just examples I'm using. I don't mean to disparage these particular firms.)

Fool s speak up
On our Discount Brokers discussion board, some Fool Community members shared similar thoughts on reinvesting dividends. You're welcome to read the whole discussion, but I'll offer a few tidbits here:

  • kahunacfa said: "I never re-invest the dividends paid by companies in the shares of the company that paid the dividend -- simply because that company may not necessarily be the best stock to buy at the time the company pays the dividend; it is a real pain to keep track of the cost basis of the shares. I do own several good dividend-paying stocks: Altria, ConAgra (NYSE:CAG), and Pfizer. I have owned CAG since 1977 and MO since I bought a lot of it at $20.0625 in the year 2000."
  • DeltaOne81 concurred: "Sure, you should absolutely take your dividends and invest them again, but there's no rule that it has to be automatically reinvested back in the same security. Collecting your dividends from a quarter (or a couple quarters) and then distinctly choosing what to [buy with that] money . is just about as good, if not better, than an automatic DRIP [dividend reinvestment plan] policy." This was in the context of evaluating brokerages, so DeltaOne81 added: "I wouldn't put free DRIP as a high criteria for a broker. If it's a minor factor, or a tie breaker, that's fine, but I wouldn't pay higher commissions or go with a broker just for that." (You can look up some brokerages and whether they permit automatic dividend reinvestment in our Broker Center.)

Where to find dividend payers
I can speak from experience that when it's tough scraping together money to invest in stocks, dividend-paying holdings in your portfolio can put a smile on your face. You review your recent brokerage statements and -- voila! -- you suddenly have several hundred more dollars to invest, thanks to dividends.

If you're in the market for some exceptional companies that are offering respectable dividend yields and hold the promise for continued growth, you'll find a whole bunch in our MotleyFoolIncome Investor newsletter service. Take a painless free trial of it, and you'll be able to peek at the list of all its recommendations, as well as access past issues and special reports. Over the past two-plus years, the recommendations have topped the S&P 500's return by an average of about 3 percentage points, with nearly half the picks sporting double-digit returns and some 15 topping 20%.

For more reading on dividends:

Let lead analyst Philip Durell help you recognize the value in companies before the market does. Click here to try Motley Fool Inside Value .

Selena Maranjian 's favorite discussion boards include Book Club , The Eclectic Library, and Card & Board Games. She owns shares of Pfizer. For more about Selena, view her bio and her profile. You might also be interested in these books she has written or co-written: The Motley Fool Money Guide and The Motley Fool Investment Guide for Teens . The Motley Fool is Fools writing for Fools.