One of the main pillars of my early retirement is automatic reinvestment of dividends paid out by the companies I own shares of. Let me explain.
Almost all brokerage companies (Fidelity, TD Ameritrade, Scottrade, etc) all have fees that are added to every purchase and sale of assets through their firms. These fees can range from free to upwards of $9.99 a trade. That can significantly reducer your ROC, Return-on-Capital, while trying to save for retirement.
The general rule of thumb is to try to keep any trade fees below 2% of the entire transaction, although I prefer to keep fees to 1% or less. This means if you are going to be buying “X” number of shares of company “A” and your brokerage firm charges $5.00 / transaction, you should make sure your total transaction is equal to or greater than $250.00 to keep your fees at or below 2%. Although, preferably you would wait until you have $500 in capital to reducer your fee to only 1% of the transaction.
One way to make sure that you keep transaction costs low, is by setting up automatic reinvestment of all capital gains/dividends. Usually this is a setting in your online brokerage account. What you are essentially doing is bypassing the fee that your brokerage would impose on every transaction. So, every time a stock pays you a dividend, say it’s $10/year, your brokerage will automatically reinvest that money back into the stock that paid it. This can mean you end up with only a partial share of the stock, but you also just avoided a $5 fee. WIN! Eventually, and after enough dividend payouts, you may end up with another whole share of stock. That is the magic.
Buy 10 shares of company X today and you may end up with 20 shares in 5 years without doing anything, you just sit back and hold the stock while they pay you consistent payouts.
You won’t be seeing your bank accounts rise when you reinvest your capital gains/dividends this way, because instead of your bank account growing, you are growing your # of shares in X company while reducing your Cost Basis, or Cost/share. And because you are adding more shares to your portfolio automatically, you will start noticing that your dividends will grow also, since you now own even more shares of that company. It’s a truly magnificent part of investing that exponentially increases your savings, all without having to do really much of anything.
As you start to get older or are getting closer to your retirement age, you can start to turn off automatic reinvestments, and start having that money come directly to you as cold hard cash instead of buying more shares. As I get closer to getting ready to “retire” I will start switching off my auto-reinvesting and will have the money supplement my living expenses until eventually it is creating enough wealth for me to live off completely. Ahh, the magic of dividends.
Forward Yearly Dividends (reinvested automatically): $645.44