How important is reinvestment

After compiling a stock portfolio, the investor often raises the question of whether to reinvest dividend payments, or spend this money on personal needs. Regular stock purchases for dividends will help ensure higher returns by the end of the investment period. The difference is felt especially strongly over a long distance.

First you need to understand how much the portfolio’s return in case of reinvestment of dividend payments can overtake the portfolio’s return without buying securities. We took three shares (Tatneft AP, MMC Norilsk Nickel and MTS), and made a comparison over the past 10 years — from 2009 to 2018.

Suppose an investor buys stocks 10 days after the dividend cutoff is the average payout period for Russian companies. From the amount of dividends received, we immediately deduct the personal income tax rate of 13%. Next, we build the dynamics of the accumulated profitability of three portfolios (for each stock a separate portfolio) by years.

The largest profit gap was shown by preferred shares of Tatneft — the total return, taking into account the reinvestment of dividends, is 1.7 times more than the simple accumulation of dividends. In second and third place are Nornickel (1.4x) and MTS (1.3x).

How to explain such an advantage of reinvesting dividends? After each dividend payment, a new purchase increases their number in the investor’s portfolio. Accordingly, the following dividends will be paid on a larger stake. And so with each new dividend payment, the effect of reinvestment grows like a snowball, as the base for payments grows. Also, in case of an increase in the stock price, a constant increase in the positions in the securities provides an ever greater profitability in relation to the simple retention of the initial package of securities. We get the double effect of reinvesting dividends.

We will separately consider why the first five years, the yield on Norilsk Nickel shares, taking into account reinvestment, was at the same level as a one-time purchase of securities. The fact is that securities purchased on dividends decreased in value due to the subsequent depreciation. But in 2014, stocks began to grow steadily, making up for the unopened effect of reinvestment.

You need to understand that reinvesting in a downtrend further reduces the final return on shares. If Norilsk Nickel’s stock price continued to fall, then even a growth in the base for dividend payments would not help to maintain profitability at the portfolio level without reinvesting dividends. The corresponding risk should be taken into account when including securities in a falling trend and relatively unreliable shares (for example, third-tier securities) in the portfolio.

For a more visual representation of how reinvesting can affect the final return, we additionally examined the dynamics of the accumulated return on shares with different average annual growth rates (from 5% to 25%). As a dividend yield, we took the average indicator for Russian companies in 2019 — 7%. It is assumed that dividend payments are made once a year. The darker color in the table indicates the full return on shares, taking into account the reinvestment of dividends.

In our example, a ten-year stock return with reinvestment of a 7% dividend outperforms the strategy of simply buying securities without reinvestment by about 1.4 times.

The dividend reinvestment strategy involves long-term investments, so sooner or later the investor will face the issue of rebalancing the portfolio. The older a person becomes, the usually lower his risk tolerance; accordingly, the portfolio structure may change in favor of more reliable securities.

One popular option is age-adjusted diversification. There is a common strategy among investors: to determine the share of shares in a portfolio, you need to take away your age from 100, and the rest is given for bonds. For example, a person aged 40 will have 60% in stocks and 40% in bonds.

So the reinvestment approach described above can also be embedded in this popular strategy. Only investments of received dividends can be made not back into stocks, but into reliable bonds. Thus, a long-term investor can just gradually reduce the risk of his portfolio in favor of debt securities.
In conclusion

The choice to invest dividends in the purchase of shares or not remains with the trader. The longer the investment period and more often the dividend payments on portfolio securities, the stronger the effect of reinvestment. As a rule, with a maturity of more than 5 years, a competently designed growing portfolio with regular stock purchases will noticeably outperform the portfolio without reinvesting dividends. Experienced investors can keep dividends «on hand» for some time to buy securities at a more attractive price.