First of all, I am going to briefly describe what dividends are. Dividends are simply payments made to stockholders on a per share basis. Usually dividends are paid in cash but occasionally a company may issue a stock dividend (you would be given more shares of stock usually based as a percentage). Some companies issue dividends on a per year basis while the majority of companies issue dividends quarterly. Now that you know more about what a dividend is, let's take a look at why it is so important to reinvest them.
Let me give you an example: $5,000 invested in Altria (MO) at the beginning of 1976 would be worth about 1.4 million today with all dividends reinvested. Now if you take the same $5,000 investment from 1976 but do not reinvest dividends, the total value today is only $375,000, over a 1 million dollar difference by not reinvesting dividends. Furthermore, the difference is not because Altria has paid you over a million dollars in dividends over 30 years. What happens when you reinvest your dividends is that you gain more shares of stock allowing you to compound the return of your original dividends. Not only do you gain extra value when the shares go up, you also will be earning dividends off previous dividends that have been reinvested into stock. Over time as the stock price fluctuates, you will be gaining more shares when the price is low, and fewer shares when the price is high. In effect, you are dollar cost averaging with your reinvested dividends.
Most companies that pay dividends have DRIP (dividend reinvestment) plans. These plans allow you to sign up to have your dividends automatically reinvested in more shares of stock. In addition, most of these plans are offered as a free service to shareholders and they will purchase fractional shares. Of course, if a company does not have a DRIP plan it might not be practical for you to reinvest dividends if you have to pay a commission each time. In most cases, you are still required to file taxes online or on paper on dividends even if you don't receive them as cash. Thankfully though, this task is made simple by using one the many free tax estimators available
online, or you can check with your tax professional and plan accordingly for taxes on the dividends. Finally, dividend reinvesting works best when you are investing for the long term. This allows more time for your investment to compound. If you are looking at a shorter term outlook, dividend reinvestment may not be for you.