Friday, 24 April 2015

Financial Basics 11 - Optimum Frequency to Reinvest Cash Dividends and Interest

This post is about the frequency at which you should re-invest the cash dividend (or interest) payment you receive from your ETF funds.

Normally you will received dividends or interest from mutual funds or ETFs either monthly or quarterly. Many stocks return dividends quarterly.

If you are familiar with Mutual Funds, you will know that you can elect to have dividends automatically re-invested in shares of the mutual fund. The purchase of the funds from the dividends is done without any visible cost, but it does cost you as it is covered by the management fees of the mutual fund (which you pay every year you own it).

Normally ETFs will pay the dividends as cash to your investment account. With some ETFs in some investment accounts you can sign up for a DRIP (Dividend Re-Investment Program), but this is not that common. So you are going to receive cash in the cash portion of your investment account on a regular basis.

I used to think that not having an automatic dividend re-investment for ETFs was a drawback, but I have now come to the conclusion that it is not, and now I actually prefer getting my dividends in cash. Why?
  • You should be either actively saving (during employment) or actively withdrawing (during retirement) from your investment accounts.  During the saving phase, you are adding cash to your investment accounts and purchasing additional ETFs. When you make these purchases from the saved cash you can include the cash from the dividends and re-invest at the same time as you invest. You are likely purchasing ETFs every 2 or 3 months, so the dividend cash does not sit idle in the account very long.
  • During the retirement phase, you will be actively withdrawing cash from your investment accounts. The dividend cash may make up a substantial portion of the required withdrawal. The portfolio I recommended in post #7 has an average yield of 2.3%, so if you are following a 4% withdrawal rate, then only the other 1.7% need be made up from sales of units. If you did not receive the dividend as cash you will have to sell more shares, including the ones that were just re-invested, which will also invoke higher capital gains taxes.
  • You can use the cash dividends to re-balance your portfolio. If you are re-balancing and your calculation shows that you should buy just one ETF in your portfolio, then you can use the cash that was received from all the ETFs (in the same account) to make that purchase. If all your cash was re-invested automatically through a DRIP, you may have to sell some ETFs and buy others to bring the portfolio into balance. 
  • Automatic dividend re-investment creates more bookkeeping work for you when you keep track of your capital cost basis for your funds (in your taxable account). More on this in a later post regarding a spreadsheet to help you keep track of this. 
Even though you will re-invest the dividend cash with your new investments most of the time, you may have some accounts in which you are not actively investing. In these accounts the dividend cash will build up and we will have to make a specific purchase to re-invest these funds. For example you might have a LIRA from a former employer's pension plan, to which you are not adding any funds.

So the question is: How often should I re-invest the dividend cash?  Each purchase costs me $10, so I don't want to spend too much on transaction fees.  However if I let the cash sit too long in the account, I am losing out on future dividends (or interest or capital gains) that I could get by investing that cash in an ETF. 

The answer involves a little bit of Algebra and Calculus, so here goes:

We have a monthly inflow of cash to the account. We let the balance build for a number of months, and then we re-invest the cash into the same ETF in the account. Over that period of months we have two costs. The first is the transaction cost to purchase the ETFs. The second is the cost of the lost return from the cash by letting it sit in the account as cash, not as an ETF.

The table below shows an example of this. We receive $100 per month in dividends. After 5 months of dividends we re-invest the $500. We need to find the optimum period of months when we should do the re-investment.


Here's the math

So if I had a fund with a $100 cash dividend per month, a $10 transaction fee and I considered the total return for the fund to be 5%, then I would reinvest the cash every 7 months and the amount I would reinvest would be $700. 

N = sqrt(24*10/(100*0.05)) = 6.92, which rounds to 7 months. 

The table below shows the optimum re-investment period (in months) for different monthly income, return on capital rate and transaction cost. 

Optimal Re-investment Period (months)
InterestTransactionIncome or contribution per month ($)
RateCost ($)5010020050010002000

This table for the same parameters shows the cash balance in the account when the re-investment is made. 

Amount of cash in account when re-investment transaction is made.
InterestTransactionIncome or contribution per month ($)
RateCost ($)5010020050010002000

Disclaimer:  These posts are not fully comprehensive financial advice.  You should seek your own qualified investment, tax and legal advice.

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