Maximizing your investments: best practices for rebalancing dividend reinvestments

With high corporate profits and cash on hand, and near record-low dividend payout ratios, many investors are wondering if they should take the cash or reinvest it. The question is, does dividend reinvesting help or hurt portfolio performance when regularly rebalancing portfolios? And how will dividend reinvesting affect diversification, costs, and taxes?

The primary reason to reinvest dividends is to buy more shares and build wealth over the long term. According to Hartford Funds, the average dividend payout ratio over the past 96 years has been 56.3%; as of December 31, 2022, the payout ratio stood at just 37.1%—leaving plenty of room for growth.

Portfolio rebalancing involves reducing risk by adjusting asset allocation, while also considering the client’s underlying objectives and preferences. Here are a few key considerations for navigating dividend reinvesting and rebalancing.

Comfort from volatility

As uncertainty at home and abroad churns the financial markets, income-minded investors seeking protection from market volatility may find dividend-paying stocks attractive and stake a place for them in their equity portfolios. Dividend-paying stocks can potentially provide investors with current income regardless of market conditions by mitigating portfolio losses when stock prices decline.

Cost controls

One of the best ways to keep portfolio management costs under control is to rebalance with cash from dividends, interest payments, and realized capital gains. Not only can it help satisfy a client’s rebalancing needs, but it’s also especially effective for taxable portfolios. Rather than clients paying taxes on withdrawn earnings, they can simply redirect those funds to underweighted asset classes.

Tax-advantaged accounts

To implement a rebalancing strategy effectively, it is advisable to use a tax-advantaged or tax-free account. This typically involves holding a combination of assets in taxable and tax-free accounts, which increases the likelihood of making significant adjustments within the tax-advantaged accounts. If the overall portfolio deviates from its target allocation, you may consider adjusting in a retirement account.

Potential tax savings

Dividends benefit from potentially favorable tax treatment. Most taxpayers are subject to a top federal tax rate of only 15% on qualified dividends, although certain high-income taxpayers may pay up to 23.8%. However, this is still lower than the current 37% top rate on ordinary income.

Re-directing cash flows

With taxable accounts, one way to rebalance is by directing reinvested distributions into underweighted asset classes. For example, when a portfolio allocation has drifted beyond the plan’s target allocation threshold, it might make sense to reinvest dividends to the underweighted side until the portfolio is back at the target allocation. On the other hand, it may be wise to withdraw funds from an asset class that is overweighted.

For clients taking the required minimum distribution from their retirement accounts, but who don’t need the distribution for daily living expenses, those assets can also be reinvested to increase the allocations to an underweighted asset class in non-retirement accounts.

Rebalancing best practices

There are times when reinvesting dividends may not make sense, such as when a client is close to retirement and needs the money, the stock or fund is not performing well, you need more diversification, or the portfolio is thrown off-balance.

Here are a few things to consider:

• Watch your weight

Securities that offer higher yields and faster growth tend to accumulate at a quicker rate than other assets, which may eventually lead to an overweighted portfolio in a few investments. This could result in higher potential losses if those investments do not perform well, compared to a more balanced portfolio.

Dividend-generated cash can be redirected to the most underweighted investments. This can help supplement portfolio rebalancing and reduce the need to trigger sales of investments that are up, which could have transaction costs and capital gains tax implications.

• Consider costs

Using dividends for supplemental rebalancing could mean relatively modest dollar amounts compared to the size of the portfolio, and flat-dollar transaction costs can add up quickly on small purchases. These transaction costs can be reduced by accumulating dividends over time and only using those dollars to execute a rebalancing trade you reach a cash threshold that makes it more attractive from a transaction cost perspective. However, systematically accumulating cash to wait for a rebalancing opportunity could create a drag on the portfolio’s long-term returns since that funds remain in cash for a period of time.

• Make it relative

When is it worthwhile to use cash from dividends? It depends heavily on the magnitude of those cash flows, the size of the portfolio, and the amount of transaction costs relative to the available reinvestment dollars. For those whose transaction costs are higher, but dividend reinvestments are low or no cost, it may be preferable to reinvest dividends and sell shares later to rebalance if, when and as necessary.

On the other hand, if dividends can be invested with no transaction charges, even at small dollar amounts, it will arguably still be more efficient in the long run to use the cash, accordingly, reducing other prospective transaction costs and the potential need to rebalance out of investments that would trigger capital gains.

Staying on track

Portfolios can deviate from their intended asset allocation over time due to market movements, dividend payments, and asset distributions. It is essential to monitor portfolio allocations and rebalance, as necessary.

But portfolio rebalancing does not have to be complicated. By following best practices and making the process more efficient, you can improve portfolio performance without sacrificing risk control.

The right rebalancing solution can help maintain your portfolio’s desired balance by regularly analyzing performance and automatically identifying the appropriate assets to buy and sell according to the target allocation. At the end of the day, it is all about ensuring your clients’ investments are on track for their long-term goals while streamlining the investment management process.