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Dividend Reinvestment FAQs

I thought I’d do something different with today’s article. Below are a few questions — from different readers — about various aspects of reinvesting dividends. None of them required a long enough answer to constitute its own article, but the topics in question are likely to be of interest to other readers.

“I’ve read that from 1960 until now, 82% of the stock market’s overall return is from reinvesting dividends. But I’ve also seen that dividends are usually only 2-3% in a given year, whereas the market’s overall return might be something closer to 8%. I guess what I’m asking is why are dividends so much more important than the increasing price, even though they are a small part of the return?”

It’s not that the dividends are more important than the price appreciation. It’s simply that they are a significant part of the return, and leaving off a significant part of the return dramatically reduces the overall accumulation over an extended period. (This is the same reason that mutual fund expense ratios are super important.)

The longer the period in question, the more pronounced this effect. For example, a $1 initial investment that grows at 8% per year for 75 years will come out to about $321. Reduce the return to 7% instead, and the final result is just $160. In other words, reducing the return by one eighth cut the final value by half. If you instead reduce the return from 8% to 6%, you end up with just $79 — a one-quarter reduction in return reduced the final value by more than three quarters.

That’s why when you read about statistics regarding the importance of dividends over several decades, you see very pronounced effects. Any change to the rate of return will have a magnified impact on the ending value. The effect is smaller if we look at periods that are shorter but still significant over a person’s lifetime (e.g., 20 years).

To reiterate, dividends are important, because they are a significant part of the overall return. But the idea that they are far more important than the price appreciation is simply a misunderstanding of the math involved.

“Why does the price of a mutual fund fall when it pays a dividend?”

In short, the price falls because the fund has less assets, which means it’s less valuable. (The same thing happens with individual stocks, by the way.)

For example, imagine that a fund has a net asset value (NAV) of $25 per share on a given day, made up of $24 worth of various stocks holdings and $1 of cash. Then the fund declares a $1 cash dividend.

Anybody who buys the fund before the ex-dividend date will essentially be getting $24 worth of stocks and $1 of cash. Anybody who buys after the ex-dividend date will be getting just the $24 worth of stocks. Point being: the price should fall by $1 on the ex-dividend date. (Of course in the real world it’s messier than that, because the prices of the various underlying stocks would also be moving around from one day to the next.)

To be clear, the fact that the price falls on the ex-dividend date doesn’t mean that you lose something when your fund declares a dividend. The price falls, but you now have an equivalent amount of cash in your brokerage account. (Or, if you reinvest the dividend, you’re in exactly the same place as before, tax considerations notwithstanding.)

“Should I set my mutual fund to automatically reinvest dividends?”

Maybe.

Having dividends automatically reinvested means that your money begins to earn a return sooner, which is a good thing.

But, if the account in question is a taxable account, it also means that there’s more tracking to be done, because you’ll have a greater number of dates and prices at which you purchased shares. But if you aren’t tracking your cost basis yourself anyway (e.g., you’re using the “average cost” method, and you are relying on your brokerage firm to calculate such for you), then the additional complexity doesn’t much matter. (To be clear though, I would encourage you to keep your own cost basis records, rather than completely relying on another party.)

You should also be aware that automatic reinvesting of dividends could result in a wash sale if you sell the investment in question at what would otherwise be a loss. Generally, this would not be a major reason not to reinvest dividends, as the effect would usually be small. But it’s something to be aware of so that you can report your taxes appropriately.

“How do I calculate the gain or loss on a sale of a mutual fund when I have had dividends and capital gains reinvested? Last year I invested $40,000 in a mutual fund, and it was worth about $40,500 at the end of the year. My dividends and taxable gains for that year, all of which were reinvested, were about $1,700 according to my online statements. Let’s say my fund’s value is $40,500 when I sell it this year. What would be my gain or loss?”

Because you have the account set to reinvest dividends and capital gains, you actually purchased $1,700 worth of shares over the course of last year. So your total basis at the end of the year was $41,700.

So if at the beginning of this year (i.e., before any new money gets invested or distributions get reinvested) you had sold all of the shares for a total of $40,500, then you would have a capital loss of $1,200 (i.e., $40,500 realized on the sale, minus $41,700 cost basis).

If further dividends/capital gains had been reinvested this year before the sale, those would be added to your cost basis as well.

Whether or not you could actually claim this loss would depend on whether or not it’s a wash sale — which it could be, if you own other shares of this same investment (or something else that is “substantially identical”) in another account.

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