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Reinvest Dividends and Capital Gains Distributions or Not?

June 20, 2020 By Jon Luskin Leave a Comment

In Larry’s Swedroe’s latest book, Your Complete Guide to a Successful and Secure Retirement, he briefly touches on the issue of reinvesting dividends and capital gains distributions. His suggestion? Don’t do it. Here’s his reasoning:

  • Rebalancing. Cash from dividends and capital gains distributions can be used to (partially) rebalance an investment portfolio. This means deploying cash from dividends and capital gains distributions to buy portfolio positions that saw the greatest relative declines, or the portfolio positions that saw the smallest relative increases in value.
Swedroe suggests using dividends and capital distributions to (partially) rebalance a portfolio – as opposed automatically reinvesting that cash back into the funds that issued it.
  • Reducing transaction costs. Using cash fund distributions could eliminate redundant transactions. This could be the case were a portfolio asset that saw the greatest relative increase had a distribution re-invested into it. Later, that re-invested distribution would have to be sold and then re-invested elsewhere (when the portfolio is eventually rebalanced). That is, it costs more to buy something, and later sell that same thing to buy something else than it does to simply buy that something else in the first place.
Not automatically re-investing cash distributions into a portfolio asset already in excess of a target portfolio weighting can mean avoiding redundant transactions – and the costs associated with those redundant transactions.
  • Reducing Taxes. In the event that a reinvested cash distribution is re-invested into a portfolio’s asset that has seen the greatest relative appreciation – it will have to be sold at a successive rebalance. This results in an avoidable tax bill.
Selling re-invested dividends and capital gains distributions can result in short-term capital gains.

As with most things in life, there are trade-offs to a strategy that does not automatically reinvest dividends and capital gains distributions. Below, some of those trade-offs are discussed.

Possible Additional Transaction Costs

Does automated reinvestment of cash distributions increase transaction costs? It depends. It can certainly mean bridging (i.e. paying) the bid/ask spread more times than necessary. Bridging that spread more times than not can certainly negatively impact one’s investment return.

Cash Drag / Excessive Rebalancing

If rebalancing is performed annually, setting dividends and capital distributions to be disbursed as cash means adding a cash drag to the portfolio – albeit small. In the time between the cash is distributed from the fund – and the portfolio is ultimately rebalanced – that cash distribution will sit in the portfolio, doing little.

The alternative is to (at least partially) rebalance a portfolio each time there are dividends or capital gains distributions. For many equity funds, this means rebalancing quarterly. For certain bond funds, this could mean rebalancing monthly. Monthly rebalancing (or re-investing of cash distributions) presents two challenges. Firstly, it’s time-consuming.

Secondly, frequent (partial) rebalancing via fund distributions results in less portfolio drift. This means less of an opportunity to buy low(er). That is, it isn’t optimal to (at least partially) rebalance portfolios so frequently. In fact, Vanguard even suggests rebalancing an investment portfolio as infrequently as between two and five years.

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Hourly Advice for Do-It-Yourself Investors. '@Bogleheads® Live' host. Advice-Only #CFP®. #fiduciary. @SDFLC volunteer. Tweets ≠ Advice. https://t.co/GJqMxem3Cr

JonLuskin
jonluskin Jon Luskin, CFP® @jonluskin ·
2h

Who's got a silly analogy about #investing in municipal #bonds?

This guy!

While you could dine at an all-you-can-eat steakhouse, you may not neccesairly want to.

(1/3)

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jonluskin Jon Luskin, CFP® @jonluskin ·
8h

Secure Act 2.0 thoughts:

With employer Roth contributions now avaiable, will more custodians make Roth individual 401(k)s available as part of their protoype (pre-approved) plans?

Right now, only Vanguard offers Roth individual 401(k)s. (Correct me if I'm wrong.)

#taxes #401k

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jonluskin Jon Luskin, CFP® @jonluskin ·
3 Feb

All else being equal, owning a big, expensive home can make (early) #retirement more difficult.

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Jon Luskin is a registered investment adviser in the states of Arizona, California, Florida, Louisiana, Massachusetts, New York, North Carolina, Pennsylvania, Texas, Virginia and Washington. The Adviser may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Currently, there are no states where the adviser is not appropriately registered, excluded or exempted from registration – allowing the adviser to work with anyone in any state. Individualized responses to persons that involve either the effecting of transaction in securities, or the rendering of personalized investment advice for compensation, will not be made without registration or exemption.

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