The Dividend Reinvestment Puzzle: What Investors Should Know

By Jonathon Marcus on August 27, 2025

Why do so many investors favor dividends—only to reinvest them? This question lies at the heart of the “dividend reinvestment puzzle,” a curious disconnect between academic finance theory and real-world investor behavior.

Theory vs. Reality

In theory, dividends shouldn’t matter. According to the Miller–Modigliani dividend irrelevance principle, in a frictionless market, a company’s dividend policy doesn’t affect its value. Investors can create their own cash flows by selling shares when needed—known as “homemade dividends.”

Yet in practice, many investors prefer dividend-paying stocks, even if they reinvest the income and face tax inefficiencies. This behavior contradicts the theoretical indifference and raises important questions about investor motivations.

Investor Behavior: A Closer Look

Surveys show that nearly 75% of investors in dividend-focused funds reinvest their dividends¹. If they’re not using the income, why do they seek it?

Possible Explanations

• Clientele Effects: Some investors—like pension funds or retirees—may prefer dividends due to liquidity needs or favorable tax treatment.
• Signaling Theory: Companies may use dividends to signal financial strength and stability.
• Bird-in-Hand Fallacy: Investors often perceive dividends as “certain” and more tangible than future capital gains, even if the latter may be more tax-efficient.

Investor Implications: What You Should Consider

🧠 1. You’re Paying Taxes on Money You Don’t Keep

Example: You own 1,000 shares of a stock at $50/share. It pays a 4% dividend = $2,000/year.
If you’re in the 24% tax bracket, you owe $480 in taxes, even if you reinvest the dividend.

Result: You’re down $480 in cash, despite not spending the dividend.

Contrast: A company that reinvests earnings into growth may increase your share price instead. You defer taxes until you sell—allowing more efficient compounding.

🧠 2. Homemade Dividends Are Often More Tax-Efficient

Example: You own 100 shares of a stock worth $100/share. You sell 10 shares to generate $1,000. If your cost basis is $80/share, you owe capital gains tax on $200 = $30 tax (15%).

Result: You keep $970 and still own 90 shares worth $9,000.

Takeaway: Selling shares when needed can be more flexible and tax-efficient than receiving taxable dividends.

🧠 3. Reinvesting Dividends Can Increase Exposure to Low-Growth Businesses

Example: You reinvest dividends from a utility stock paying 6%. Over time, the company faces rising costs and stagnant growth. You’re accumulating more shares in a business with declining prospects.

Contrast: If the company retained earnings and invested in innovation (e.g. infrastructure), long-term value might grow more—benefiting you through price appreciation.

🧠 4. Dividends Aren’t “Free Money”—They Reduce Share Price

Example: A company worth $100/share pays a $5 dividend. After payment, the share price drops to $95. You’re not richer—just moved money from one pocket to another, while triggering a tax bill.

🧠 5. Forced Inflexibility: Income When You Don’t Want It

Example: You’re working and don’t need extra income, but your dividend-paying stocks generate $10,000/year. Even if reinvested, you owe taxes annually—on money you’re not using.

Alternative: Growth stocks or ETFs let you defer taxes and access income when it suits your timeline—like in retirement at a lower tax rate.

Final Thought: Rethinking Dividend Strategies

Dividends feel safe and tangible—but they’re often:

• Tax-inefficient
• Less flexible than strategic share sales
• Potentially misaligned with your actual cash needs
• A source of increased exposure to underperforming companies

For many investors, a thoughtful plan that strategically sells shares for income—when needed—can offer better tax efficiency, flexibility, and long-term growth.

1.The Dividend Reinvestment Puzzle: What It Means For Investors,  July 29, 2025. FinancialAdvisor.com.  https://www.fa-mag.com/news/the-dividend-reinvestment-puzzle–what-it-means-for-investors-83474.html