Let’s assume the the dividend would be growing at 10% CAGR for the next 20 years. In the same period, let’s assume the market value of the stock also grew 10% compounded annually.
Having decided to hold the stock for 20 years, you can either spend the dividend or you can reinvest it.
Let’s look at the two scenario.
Scenario One : Spending the dividend.
In the given period, you’d have collected and spent a total dividend amount of $114. As $2 in year 1 will be worth more than $2 in year 20, by the end of the period the total inflation adjusted return will be $151.21.
As the market value of your stock is growing at 10%, if you exit the investment at the end of twenty years, you will get $672.
Your total returns = $672+$151.21 – $100 = $723 or 723% on your original investment.
Scenario Two : Reinvesting the dividend
For the sake of simplicity, let’s assume you reinvested the dividends in a similar security which provided a 2% dividend yield and grew at 10%. For instance, you used $2 that you got as dividend in the first year to buy $2 worth of share that provided a dividend yield of 2% or $0.04 and also grew at 10% y-o-y i.e. the $2 that you had invested grew to $2.2 in next year and so on.
If you exit this investment at the end of 20 years you will have a total of $672 + $291 = $963
Your returns on investment would be $863 or 139% more than previous scenario.
Another interesting thing to note is if you chose to remain invested in the security but started using the dividend, you will start collecting a total dividend of $17.23 or 40% more dividend from the previous scenario from 20 years onward.
This difference in returns gets staggering with time.
If you chose to reinvest the dividend for 30 years instead of 20, your total investment value will become $2995 as against $2059 if you didn’t invest the dividend –a difference of 936% in total returns!
It doesn’t stop there!
The real power of reinvesting the dividend is in the silver lining it provides.
By buying the shares every single year at around the same time for 20 years you are essentially practicing something called dollar cost averaging (although technically you are buying with more dollars year after year) and there’s a good chance your returns will be better than average as you will be buying more shares when the price is low and less when the price is high thereby significantly reducing the average price you bought the shares for.
Another possibility is when you get the extra cash as dividends, you can choose to wait till the market presents the opportunity to buy the shares at ridiculously low price. If you do that, you returns will be much higher than all the previous returns!
A Real Life Example Of Dividend Reinvested
If you had bought $10,000 worth of shares of Coca Cola in 1962 and not reinvested the dividend you will get $136,270 in dividend and $503,103 after selling the shares after 50 years making a total of $639,373 as against $1,750,000 if you had reinvested the dividend in the same stock– a staggering difference of $1,110, 627!
Which One Should You Choose
It really boils down to the question of if you want to enjoy the benefit of your investment now or can wait for a few decades. The obvious downside of reinvesting the dividend is you don’t get to use the dividend income in funding your aspirations.
Following this discretion, my suggestion is reinvesting the dividend if you are young now because then you can really tap into the power of compounding. This is essentially my plan. I don’t need to use the returns from my investment for the next 20 to 30 years, at least not until I choose to retire from my job. So I can keep reinvesting my dividend income.
If you are towards the later half of your life, however, I think it’s best to reap the benefits of your investment that comes in the form of dividend.