What You Don't Know About Dividend Reinvesting Can Hurt

Reinvesting dividends can help stretch your retirement savings, but it also adds costs and complication.

Money in human hands closeup

Make sure your investment does not throw your allocations out of line. It might not seem like a big deal, especially if you are thinking about a dividend paying 1 percent or 2 percent on common shares. But if you are in a speculative high-yield bond fund that manages a 10 percent yield and you are automatically reinvested, it could throw your portfolio out of whack in a hurry.

[Read: Understand the Science of Saving for the Future.]

Even reinvesting relatively small payouts can gradually nudge your allocations away from where you'd like them. "Over time, reinvesting dividends can push your portfolio out of balance compared to your target asset allocation," Rodgers says.

Make the most of compound interest by staying invested. Reinvesting "keeps you from having a cash drag on your returns if you do not reinvest the cash dividend right away," Rodgers says. The upside to automatically adding to your investments is that you're saving no matter what. Behavioral finance studies show that by making your savings automatic, you are more likely to save than if you need to actively choose to do so. In a study published by the National Bureau of Economic Research, Harvard University researcher Brigitte Madrian found that the number of participants in workplace savings plans nearly doubled when people were "auto-enrolled," compared to the number who did so if they needed to opt in to a plan. Dividend reinvesting applies the same principle.

While people investing in equities have often ignored dividends, they are worth paying attention to and can add up to big money over time. Rodgers notes that the S&P 500 index is up about 53 percent over the past five years. If you followed a plan of reinvesting dividends on S&P shares, your return would be 71 percent. So the upside is there if you are committed to owning stocks and can handle their associated risk, and if you don't need dividends for other purposes like income.

"If the client is in the distribution phase of their life, I will most frequently recommend that they not be reinvested," Balaban says. "I don't believe introducing market risk into the equation is in the client's best interests when I know the income is going to be withdrawn."