A basic strategy for many investors seeking to earn money in the stock market is to be a long-term investor, and allow their money continue to grow. If you own a stock that regularly pays a dividend, you may wish to reinvest this dividend in order to take advantage of compounded growth. The decision to reinvest dividends or take the money in cash is dependent on the situation of the individual investor.
If the stock market is not overvalued, and particularly if you expect that the market will rise in value, dividend reinvestment plans have an advantage. The earnings from stocks or mutual fund investments, paid as dividends and used to purchase more shares, have a potential to grow as the investments rise in value. The effect of this reinvestment is similar to dollar cost averaging, which advocates investing constant amounts into the market regularly. Reinvesting when the market is low allows you to purchase more shares of stocks or mutual funds that have a greater potential for increase.
Heavy in a Sector
Individual stocks with dividend reinvestment purchase additional shares of the same stocks. Some stocks, such as those in the financial sector, have a history of paying higher dividends in relationship to stock value. Since these higher dividends are invested back in the same stocks, it can increase an investor's holding in a specific sector or company to a level where he is no longer diversified, and make him more vulnerable to a downturn in a specific market sector.
High Market Value
If the stock market is high, and you expect it to drop over the next several months, it may be a good time to stop your dividend reinvestment and take the dividends in cash. Reinvesting the dividends under these conditions results in the purchase of fewer shares then when the market is more favorably priced, and also increase the investor's exposure to potential losses. Holding dividends in a cash or money market account may help preserve the value of the dividends when a down market is expected.
While mutual funds generally allow for automatic reinvestment of dividends and periodic additions to the funds, stocks do not routinely allow for this without paying a commission. When a shareholder agrees to use automatic dividend reinvestment, the dividends purchase more shares without the buyer paying commissions. Many stock dividend reinvestment plans also allow for an investor to make periodic additional investments without paying a commission on the new purchases.
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