The Impact of Dividends

Should our Practical Investor reinvest dividends or use the cash to buy new stocks?

As I was working on this month’s cover story about the challenges of selling stocks, I had an epiphany. A financial planner and I were discussing the psychological hurdles in­vestors often face before pulling the sell trigger, when I suddenly realized we could have been talking about me.

Selling isn’t usually a problem for me because I’m a classic buy-and-hold investor. But my “Practical Investing” portfolio forces me to sell stocks far more often than I’d like. That’s because the portfolio is static; I don’t add cash to it or withdraw money from it.

For those of you who are new to this column, I launched the portfolio in October 2011 with $200,000. Now, some 30 months later, the account is worth $307,962 (including shares in the stock-market index fund against which the individual stocks are measured), thanks to the stunning bull market. (Although my portfolio has gained 53%, it is barely beating its benchmark.) Aside from the initial nine months, during which I seeded the portfolio with stocks, it has been 99% invested for the bulk of its existence.

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Thus, when I want to add a new stock to the portfolio, I have only two ways to come up with the cash to pay for it. The first is obvious: I could sell something. For example, I recently pared back my stake in Spirit Airlines (symbol SAVE (opens in new tab)), my biggest winner, selling 300 shares for $18,092 but hanging on to 83 shares. The stock has climbed 322% since I bought it in 2011 and now trades for about 20 times projected earnings. Analysts remain bullish on Spirit, but at such a lofty valuation, the risks are high if the company fails to live up to expectations.

My other option is to stop reinvesting dividends, let the payouts accumulate and use the cash to buy new stocks. Last year, the portfolio collected a tidy $5,400 in cash dividends. The total is likely to be higher this year because I reinvested those distributions to buy additional shares of the companies that paid them.

But I’ve been reluctant to use dividends as a source of funds for new purchases. That’s because I wanted to make a point about how important the payments are to the returns of individual stocks as well as the portfolio as a whole. Since 1926, dividends have accounted for some 40% of the stock market’s annualized total return of about 10%, according to Morningstar. And dividends help stabilize returns because companies generally pay them whether stock prices are rising or not. That means in down markets, dividends account for

an even larger portion of returns. So high-yielding stocks are likely to buoy your portfolio when times are tough, but they may cause it to lag when stock prices soar.

Case in point: Apollo Commercial Real Estate Finance (ARI (opens in new tab)). I purchased 625 shares of the mortgage-owning real estate investment trust in March 2012 for $16.02 per share. As of April 4, the shares had climbed a paltry 4.4%. But Apollo boasted a 10% dividend yield when I bought it and still yields 9.6% today. So the stock’s total return since I’ve owned it is a much more palatable 26%, thanks to compounding of those reinvested dividends. Plus, Apollo is much less volatile than the market as a whole. I may not love that sluggish appreciation when the market rises, but I’ll appreciate the stability when the market falls.

Seeking reader input. If I stop reinvesting dividends, a stock such as Apollo will appear to be a huge underperformer, even though it will be feeding the portfolio with a steady stream of cash. The question is, do you, dear readers, care more about the returns of the individual holdings, or are you mostly interested in the performance of the portfolio as a whole? Please e-mail me at kkristof@kiplinger.com (opens in new tab) and let me know your thoughts. I’d love to hear from you.

Kathy Kristof
Contributing Editor, Kiplinger's Personal Finance
Kristof, editor of SideHusl.com (opens in new tab), is an award-winning financial journalist, who writes regularly for Kiplinger's Personal Finance and CBS MoneyWatch. She's the author of Investing 101, Taming the Tuition Tiger and Kathy Kristof's Complete Book of Dollars and Sense. But perhaps her biggest claim to fame is that she was once a Jeopardy question: Kathy Kristof replaced what famous personal finance columnist, who died in 1991? Answer: Sylvia Porter.