Dividend reinvestment has long been touted as one of the great ways to build up a stock or mutual fund portfolio over time, and it works for exchange-traded funds (ETFs), as well. There are several ways investors can do this, and the best strategy for you will depend upon your risk tolerance, time horizon, and investment objectives.

Dividend Reinvestment Plans – DRIPs

The simplest and most straightforward way to reinvest the dividends that you earn from your investments is to set up an automatic dividend reinvestment plan, either through your broker or with the issuing fund company itself. This way, all of the dividends that are paid will immediately be used to purchase more shares of the underlying investment without you having to do anything. This can be the best option if you intend to own your funds for an extended period—five years or more.

Some plans and funds will allow for the reinvestment of fractional shares, while others may only allow you to buy whole shares. If your plan falls into the latter category, you may need to occasionally purchase another share or two with the cash that’s paid to you in lieu of fractional shares. This strategy is also a form of dollar-cost averaging since it will automatically buy more shares when the price is down and fewer when it is high.

One key to remember here is that if you set up your DRIP through a brokerage firm, commissions may be charged for each reinvestment. If you hold your shares directly with the fund company, on the other hand, this service is usually provided for free.

Reinvesting by Timing the Market

Another strategy some investors use is to have the dividend payments deposited into their brokerage accounts. Once enough cash accumulates, the money is used to buy more shares of the dividend-paying item or another security that is trading at a low price. By buying at a market low, the investor achieves a superior cost basis. Opponents of this approach argue that having that much money on the sidelines for that long is counterproductive because it could have been used to generate further dividends if it had been reinvested immediately.

Of course, the outcome of this strategy versus automatic dividend reinvestment depends entirely upon how well the investor can time the market using the second approach and the dividend yield of the new securities being purchased.

Another version of this strategy is to wait until the market becomes undervalued before reinvesting. Again, the returns that can be had from this approach will depend upon the factors listed above.

Buying an Index Fund

You may want to consider using the dividend income to buy another security such as an S&P 500 Index fund. One of the big disadvantages of most index funds is that they don’t pass dividends through to investors. But, if you like index funds and are reaping material dividend income from an ETF portfolio, go ahead and pump that money into your index holdings as a way to simulate the real growth of that index—with dividends at least partially factored in. This can yield handsome returns over time, as historical figures show that an index will likely post substantially higher returns when you factor in dividend reinvestment.

You also could use your dividends to buy an investment in another sector. If you have a large portfolio of ETFs that is primarily designed to generate current income, try using some or all of your dividend income to buy something more growth-oriented, such as a technology ETF with a solid track record. This can help to balance your portfolio.

Retirement Plan DRIP

If you want to set up a DRIP that purchases more shares of the company for which you work, the best way to do it may be inside your company 401(k) plan—if your plan allows this and you don’t intend to use any of the proceeds until retirement. The advantage here is that you will not pay income tax on your dividends until you withdraw from the plan, and the net unrealized appreciation rule allows you to peel your shares off from the rest of your plan assets and sell them in a single transaction at retirement.

As long as certain rules are followed, you will receive long-term capital gains treatment on your sale, which will substantially lower your tax bill. You may want to allow your dividends to pay out in cash during the year before your sale, so you don’t have to worry about calculating long- versus short-term gains or losses in the year of sale.

The Bottom Line

Reinvesting your dividends is almost always a good idea if you intend to hold your shares for the long term and don’t need the income now. For more information on dividend reinvestment and how you can make it work for you, consult your stockbroker or financial advisor.