The Dividend Reinvestment Strategy
With all the investment advice you hear from advisers, brokers and Wall Street regarding reinvesting dividends, they all seem to say the same thing.
That is, reinvesting dividends is a good thing because there are no brokerage fees, it helps with compounding and you can purchase parts of a share.
This is a cop out answer. It is just regurgitated and the people who give you this advice usually do not know any better or just cannot be bother to explain both sides. Here is an article from the NYTimes on whether you should automatically reinvest dividends.
I am not saying that automatically reinvesting your dividend income is bad, but it is important to understand the untold aspect. That you may be reinvesting dividends when the stock is overpriced which is never a good thing.
The Untold Truth about Dividend Reinvestments You Should Know
As a value investor that focuses on the fundamental strength of a company to make investment decisions, I never want to overpay for my stocks.
It is exactly the same as when you go shopping. You are looking for deals. You do not want to overpay or be juped into buying something you think is not worth it.
But this happens a lot of the time when you let your dividends automatically reinvest.
If the company that you are investing in is currently underpriced, it would be ok to continue reinvesting, but what about when the company is close to or above its fair value?
The market is getting ready to sell the stock, but your auto reinvesting is set up to buy more shares.
What To Do About Dividend Reinvesting?
First thing is to ask your advisor what the fair value of your dividend paying stock is.
If the advisor does not know, that itself is an issue. But ignoring that issue for now, if your advisor says the fair value is $100 and the market price is $50, then it’s ok to keep reinvesting those dividends.
If the advisor says a fair value for the stock is $50, but it is trading for $100, then watch out.
The best thing to do is to perform your own stock valuation methods so that you do not have to rely on others.