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You have mentioned in previous articles that reinvesting dividends is a critical part of investing. What method do you consider to be the best?

The best method is the one that works for you. The purpose of reinvesting dividends is to benefit from the magic of compounding – perhaps the most powerful force for building wealth over the long run.

Compound growth – also known as exponential growth – is no fun when it is working against you. Think of someone paying 20-per-cent interest on an ever-growing credit card balance, or the speed with which COVID-19 spreads through unvaccinated populations.

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But when compound growth is working for you, the results can be extraordinary. Like the proverbial snowball rolling downhill, the gains from compounding are initially small, but over time they become larger and larger.

Consider someone investing $100,000 in a portfolio of stocks with a compound annual return – including dividends – of 9 per cent annually (which is what the S&P 500 returned over the past two decades). After 10 years the portfolio would be worth $236,736; after 20 years, $560,441; and after 30 years, it would be valued at more than $1.33-million. That’s without adding any new money but simply reinvesting dividends.

When I started investing a couple of decades ago, there weren’t as many options for reinvesting dividends. Now, the choices can be a bit overwhelming. Here’s a list to help you zero in on the method, or combination of methods, that will work best for you.

Mutual funds (1)

Mutual funds make it super easy to reinvest dividends. When you buy a fund, reinvesting dividends – as opposed to receiving distributions in cash – is typically the default choice. What’s more, there are no commissions to buy or sell mutual fund units. The main drawback is that many mutual funds have relatively high management expense ratios (MERs), which take a bite out of your dividends before they get reinvested.

Mutual funds (2)

You can minimize the high costs of mutual funds by using them strategically to reinvest dividends. If you own a portfolio of dividend-paying stocks, for example, consider using a single index mutual fund to absorb the cash that accumulates in your account. By regularly purchasing units of an index mutual fund – which have lower MERs than actively managed funds – you’ll be putting your dividend cash to work while keeping your costs under control.

Dividend reinvestment plans (1)

Traditional dividend reinvestment plans (DRIPs) have been around for decades. Their main advantage is that they let you purchase fractions of shares, which means every penny of your dividend gets reinvested. The downside: There are costs and extra work involved. First, you have to purchase your shares. Then you have to pay your broker a fee of about $50 to register the shares in your name (as opposed to leaving them in the broker’s name, or “street” form). After that, you can enroll your shares in the company’s DRIP, which is managed by its transfer agent. Many DRIPs also let you make subsequent purchases of stock without commissions, which is a plus if you plan to make regular cash contributions.

Dividend reinvestment plans (2)

Some investors (myself included) have found setting up and monitoring multiple DRIPs with different transfer agents to be a pain. Discount brokers have made the process easier by offering their own DRIPs, which let clients reinvest dividends without having to go to the trouble and expense of registering their shares with the company’s transfer agent. Broker-operated DRIPs are convenient – you can set them up with a telephone call – but one drawback is that most discount brokers will only let you purchase full shares, which means a portion of your dividend will be received in cash.

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Commission-free ETFs

Recently, my discount broker – BMO InvestorLine – began offering commission-free trades for dozens of ETFs, joining Scotia iTrade, Qtrade Investor and others who have been doing so for years. (Some brokers charge a commission when you sell, so be sure to read the fine print.) The advent of commission-free ETFs has created what I consider to be one of the most cost-effective and convenient ways to reinvest dividends. Now, when cash builds up in my account, I purchase units of low-cost Canadian or U.S. index ETFs without having to pay a trading fee. Cutting my costs further, the MERs of these ETFs are as low as 0.06 per cent.

The DIY DRIP

Reinvesting dividends doesn’t have to be a formal process. Some investors let cash accumulate and then, when they see a stock that is attractively priced, they pull the trigger. This method – which I use in my model Yield Hog Dividend Growth Portfolio – offers the most control over how and when dividends are reinvested. The risk is that, if you’re lazy or get easily rattled by market slumps, you might leave your cash sitting around for too long, which defeats the purpose of compounding.

Closing thoughts

There are lots of ways to reinvest dividends. The important thing is to find a strategy that works for you and stick with it. There’s no time like now to get that snowball rolling.

E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.

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