Why Dividend Reinvestment May Not Be A Good Idea

Question - Is buying shares only at their highest prices a good idea?

Dividend Reinvestment Is Implicitly Buy High Sell Low

There is a very enticing sweetener with the long term holdings strategy, dividends and dividend reinvestment.

Assuming that you are in a safe-ish share, you will probably be getting dividends worth something between 2% and 6% of the current share price per year

Of course this is most years, so a year or two with low or zero dividends will pull this average down.

As one of the keys to the short term holding strategy is compound growth, automatically putting dividends back into more company shares gives you this growth.

So it must be good "My mate has had shares in xyz for 10 years and he has doubled the number of shares that he owns!"

How Can Dividend Reinvestment Be Bad?

Clearly with short term holding planning for dividends can not be part of the strategy, but that does not mean that you will never receive them, just that they will be accidental.

If you do happen to be holding shares on the ex-dividend date what do you do when the dividend is paid?

The answer is surprisingly simple, probably nothing. This is because the dividend will almost certainly be too small to justify a purchase with just those funds, you may be eligible for discounted or automated schemes but you do need to be sure about any fees.

So all you can do is leave it in your dealing account and add it to the next sell/purchase cycle.

As you are on a short term holding strategy the next purchase will be only a few days or weeks away, if you are on a long term hold strategy the next purchase might be a year or two away.

In practice with a short term hold strategy it appears to be that you will be holding on ex-dividend dates less frequently that random chance might suggest.

The primary reason being that you are not always buying into companies during a dividend paying period, the share price has dropped for a reason and this reason may preclude paying a dividend.

If you are considering buying just for the dividend and then reselling than as an example on the 30th March 2017 Lloyds Bank (LLOY) has two dividends with an Ex-Dividend date of 6 April which total 2.2p per share and a share price of £0.667079. This is a dividend of 3.29%

Having £14,150 to spend gives us.
  • Stamp Duty of £70.
  • Trade fees £10 (2 * £5).
  • PTM levy of £2 (2 * £1).
  • Purchases 21,096 shares and total fees of £82.
  • Dividend works out at £464 or £382 after fees.
If you are confident that the LLOYs share price is sufficiently stable that you can buy and sell within a week or so then this is a profit worth having.

It is also very clear that it only needs a very small share price drop of a couple of percent to wipe out these profits. Typically share prices can drop alter after the ex-dividend date, or payment date reflecting the value of the dividend.

Dividend reinvestment is very attractive as you don't have to do anything and you get compound growth in the QUANTITY of shares that you own.

I have capitalised quantity because this growth in quantity may be diverting attention away from loses in both the initial purchase pot and the dividend income.

A great example of this is Barclays

If you bought at the start of 2002 by Aug 2016 you would have had a 70% growth in the number of shares that you own. However you would lose 66% of your investment if you sold today (Aug 2016) or 33% if you picked the (not available) peak price from over the last 6 years.

The reason is surprisingly simple, as a slight over-simplification profitable periods lead to higher dividends and less profitable periods lead to lower dividends..... I bet you can see where this is leading.

Profitable periods and dividend payment tends to push share prices higher and non profitable periods and no dividend payments push them lower.

So dividend reinvestment is another way of saying only buy company shares when they are at their peak price, so you get a £100 dividend, spend £5 on dealing fees and 0.5% stamp duty and then buy shares at a price that is very likely to drop.

This leaves me with the horrible feeling that Dividend Reinvestment is seen as a positive in the retail market because of two factors.
  • The refusal to accept the notion that MY money is at risk. Only naive fools buy shares in companies that go broke or whose share price drops dramatically and I am not a naive fool.

  • Dividend income is not seen as real money because it was never in your bank account, so losing it doesn't count.
Of course dividends can be used to buy shares in other companies or withdrawn as cash and held as a buffer against capital depreciation, but you mustn't forget how small the dividend will often be in terms of pounds, shillings and pence.

In many cases dividends can be lower than inflation if you do withdraw them then the value of your capital will decrease over time.