Overview – Should You Reinvest Your Earnings or Spend the Money?
For investors who own dividend-paying stocks, short-term bonds, or other income-producing investments, a day most of them look forward to is when they finally receive their payments. Upon receiving their funds, investors are presented with a seemingly trivial yet important question: what do they do with the earnings they’ve received?
Generally speaking, investors are presented with two options: reinvest their earnings, withdraw their earnings and spend it elsewhere, or some combination of the two.
Both approaches have their merits, and there will be times throughout an investor’s career when one option makes more sense than the other. However, what does each approach entail?
By having a clear understanding of what each choice can potentially lead to, investors can better decide which to go with at any given point in their careers.
Choosing to Reinvest Your Earnings
One of the major reasons why some investors choose to put their investment earnings back into their portfolios is because it’s a very simple yet effective way to grow it, without needing to contribute a substantial amount of external funds all the time, if at all.
Arguably the most powerful aspect of reinvesting is that its effect compounds, and becomes more apparent if investors have lots of capital to work with. You use your earnings to grow your portfolio, which results in an even bigger portfolio, which leads to even more earnings next time, ad infinitum.
To help encourage this behaviour, some brokerages offer their clients a choice to enroll in dividend reinvestment programs, where dividend funds are automatically used to purchase shares whenever they’re deposited into an investor’s account. As a bonus, commissions are greatly reduced or outright waived for this automated purchase of shares.
Some publicly traded companies also promote this behaviour by offering discounts on their share price if investors opt to enroll in their reinvestment programs.
With enough time, your portfolio can reach astronomical heights simply by choosing to reinvest your earnings.
To see the power of reinvestment in action, let’s take a look at the following, albeit very simplified, example.
Imagine you start with a $5,000 portfolio comprised of a single stock with a share price of $50/share – in other words, you own 100 shares. Each share pays a yearly dividend of $4/share, or $1/share every quarter.
At the end of year 1, you earn $400 in dividends, bringing your portfolio value up to $5,400. When reinvested you gain an additional 8 shares.
The following year, you earn $432 in dividends, bringing your portfolio value up to $5,832 and netting you another 8 shares.
After 5 years of reinvestment, this is what the portfolio will look like:
The growth shown here doesn’t account for an increase in stock price, increase in dividends, or external contributions to your portfolio, all of which will certainly make this growth even more impressive. The point here is to demonstrate how powerful reinvestment is, even under very simplified circumstances.
While choosing to reinvest may make sense for some investors, it’s important not to forget about the potential drawbacks as well.
One major issue that could arise is that your portfolio’s balance may be thrown off after reinvesting, that is, the amount of money allocated to specific holdings may either be too much or too little.
Imagine your portfolio is made up of 4 stocks (A, B, C, D) with the following allocations as a percentage of book value:
- Stock A: 40%
- Stock B: 25%
- Stock C: 20%
- Stock D: 15%
Chances are, your stocks all have different prices and offer varying dividend payments (i.e., each stock’s yield is most likely to be different). So, when it comes time to reinvest your earnings, it’s likely that you’ll end up buying more shares of one stock than others.
In other words, your portfolio’s balance will probably change because not every holding will grow equally.
After reinvesting, your portfolio could end up looking like this:
- Stock A: 45%
- Stock B: 35%
- Stock C: 15%
- Stock D: 5%
Fortunately, this problem can be fixed by taking the time to rebalance your portfolio, that is, sell shares of stocks that contribute too much to your portfolio and buy more shares of the stocks that aren’t contributing enough.
However, the problem with rebalancing is that because you’ll need to make several buy and sell transactions the cost of commissions can quickly pile up (more on this later), not to mention the time commitment needed to sit down and properly rebalance your portfolio, especially as your portfolio grows to include multiple investment instruments and dozens of holdings.
Another problem that investors may run into when they choose to reinvest is that they may not have enough cash on hand to meet their day-to-day cash needs.
We’ve previously discussed being asset rich yet cash poor, and how this can become a major problem if an investor doesn’t take the time to assess what their cash needs are. You can have a multi-million dollar portfolio, but that won’t matter if you don’t have enough cash on hand to pay for something as ordinary as your groceries.
Just because you reinvest doesn’t mean you’re not allowed to sell your investments to generate some cash, but if you do sell, specifically if you stand to make a capital gain, then the proceeds of that sale will most certainly be subject to capital gains tax.
Choosing Not to Reinvest Your Earnings
While some investors place a lot of focus on trying to grow their portfolios as much as possible, others may not share the same goal. Some investors are more focused on using their portfolios as a source of steady, reliable income.
Because of this difference in priority, choosing not to reinvest your earnings may be the more favourable option.
By having these funds in their hands rather than being immediately put back into their portfolio, investors can use them to repay debts, pay for daily expenses, or reinvest into their portfolio at a later time: the possibilities are endless.
If you do choose to reinvest the funds into your portfolio sometime down the road, then you have full control over how much to allocate to each investment. There’s no need to worry that your portfolio’s balance will be thrown off because you can decide exactly how much money to allocate to each holding.
Naturally, this approach has its fair share of drawbacks as well.
One that immediately comes to mind is that if you decide to reinvest at a later date then you will be charged a commission for every trade you perform, unlike some automatic reinvestment programs which waive or greatly reduce this.
While some brokerages charge commissions as a percentage of a trade’s total value, others charge a flat rate regardless of order size.
Therefore, if you decide to reinvest down the road it would be wise to carefully plan out how many trades you decide to perform. Failure to properly plan your trades could easily result in commission fees quickly piling up and evaporating your funds.
Another problem you could potentially face is that your portfolio won’t grow nearly as much as you’d expect.
Now, there’s no problem with choosing to take your investment earnings and spend it on other things, but if you consistently take all your earnings and never reinvest any of it, then your portfolio’s growth will be extremely limited.
No reinvestment whatsoever means no additional investments are purchased and no new holdings are added regularly. The only way your portfolio would grow is through capital appreciation, which isn’t going to massively contribute to growth if you own only modest holdings.
A $10 increase in share price will only result in a $10 increase in portfolio value if you hold one share, but a $1,000 increase if you own 100 shares. If you don’t put some money back into your portfolio then don’t be surprised if its growth stagnates.
Is One Choice Better Than the Other?
Between the two approaches, is one “better” than the other? Not necessarily. Many factors contribute to which choice to go with, such as an investor’s goals, how far along they are in their investment careers and their personal circumstances.
If your goal is to keep growing your portfolio for many more years, or even decades, to come, while at the same time not expecting to have any dependents (e.g., children, aging parents) soon, then perhaps it makes sense to keep reinvesting.
On the other hand, if you feel that you’ll constantly need your investment earnings to pay for certain expenses and you aren’t comfortable with having to re-balance your portfolio now and then, then maybe choosing not to reinvest is the better choice.
Regardless of what approach you decide to take, everything starts with understanding what exactly you want to achieve as an investor, whether in the future or at a given point in time.
Wrapping Up
Upon receiving earnings from their investments, some investors opt to immediately put it back into their portfolios, while others decide to take the money and use it for other purposes.
Whether you decide to reinvest your earnings or not, it’s important to understand that both approaches have their pros and cons and that one isn’t automatically a superior choice to the other.
Deciding to reinvest or not all boils down to the individual investor, and understanding what exactly it is they hope to achieve by either keeping the earnings in their portfolio or taking it. Only when an investor knows what sort of goals they want to accomplish will they know which approach works best for them.
