When you look at the stocks sitting there in your portfolio, do you think: (1) I need to diversify more, (2) I need to own higher quality companies, (3) I need higher current income, and/or (4) I need to own companies that have better earnings per share growth rates. If those thoughts dominate when you size up your portfolio, it probably makes sense to pool your dividends together and make opportunistic investments that can alleviate that concern.
Want something higher-quality? Take your dividends and add some Procter & Gamble, Johnson & Johnson, or Coca-Cola to your portfolio.
Need higher current income? Take those dividends and buy GlaxoSmithKline, AT&T, or BP.
Need higher earnings per share growth rates? Take your dividends and purchase shares in Disney, Becton Dickinson, or Visa.
Pooling dividends together and selectively adding to the area you seek to improve is the easiest way to rebalance when you have an aversion to selling anything—particularly the companies that have done well and come to represent a higher overall portion of your portfolio.
On the other hand, imagine a person with a thirty-nine stock portfolio that consisted of: Exxon, Chevron, Conoco, Royal Dutch Shell, BP, General Mills, Kraft, Nestle, McDonald’s, Philip Morris International, Disney, Becton Dickinson, Johnson & Johnson, GlaxoSmithKline, Hershey, Brown-Forman, Anheuser-Busch, Coca-Cola, PepsiCo, Dr. Pepper, Procter & Gamble, IBM, General Electric, Wells Fargo, Emerson Electric, JPMorgan, Aqua America, Southern Company, McCormick, Sysco, AT&T, Visa, Wal-Mart, Clorox, BHP Billiton, Unilever, J.M. Smucker’s, Kellogg, and Campbell’s Soup.
All that person needs to do is stay alive. There’s no need for further diversification. There’s no real need to tweak things. If you’re doing fine financially and don’t need the income to spend, you should just automatically reinvest because it’s unlikely you can improve much upon a portfolio composition like that. You’ve built a great ship, now get out of the way, and let it sail.
But a lot of people aren’t there yet—they might only have ten or so of the stocks owned, and have a long ways to go towards their ideal diversification. In that case, it makes sense taking the dividends and looking elsewhere. For other people, they own a lot of second-tier and third-tier companies, and they want to remove their dividends from them to upgrade the quality of their portfolio as ongoing portfolio maintenance in preparation for the next recession. Still, others may find themselves sticking on an initial portfolio construction of cash cows like AT&T, GlaxoSmithKline, and BP and want to use those generous dividends to fund some higher growth opportunities.
You’ll never get a definitive answer to this question because both sides are right. Someone advocating automatic reinvestment into Coca-Cola is going to say, “How can you improve upon the best company in the world that is growing 8-12% annually, and why on earth wouldn’t you want to arrange your affairs so that you always own more, more, more of such an outstanding business?” Someone on the other side of the debate might say, “I need to take dividends and buy higher-quality companies that are built for the next 25+ years”, and how could you argue with that sentiment?
The way I see it? In the early stages, it makes sense to automatically reinvest. There’s no need to fuss over $5, $10, and $15 dividend checks. Let the positions grow and get your savings rate up. In the middle stage, when your dividend checks are of the “$800 here, $950 there” variety, it makes sense to pool them together as cash and then complete your portfolio as you see fit. Towards the end, when you’ve got three dozen firms sending you dividend checks above what you need to live, it seems wise to take what you need and automatically reinvest from there. There is a point where you own all the companies you want, and the need for constant optimization disappears because even going on autopilot will keep on increasing your wealth beyond your wildest dreams when you first started.