Investors who do not need to spend their dividend income have two basic methods for dividend reinvestment: automatic and selective. I will discuss each method and explain why I selectively reinvest dividends. I will not cover all aspects of each method (e.g., dollar cost averaging associated with automatic dividend reinvestment), so I encourage readers to do further research if they are interested in knowing more about this topic.
Automatic dividend reinvestment involves passively reinvesting dividends back into the stocks of the companies that paid them. There are two typical ways to implement this method. One way is to enroll in a company-sponsored dividend reinvestment plan (DRIP), which involves buying shares directly from the company or through their agent. Instead of receiving your dividends in cash, they are automatically used to buy more shares of the company's stock at the current market price, although some companies provide small price discounts. Many companies offer no-fee DRIPs (a list of such companies can be found here), although be aware that other companies charge fees (e.g., initial setup fees), so it is important to find out the details of a given company's DRIP before enrolling in it. Many company DRIPs also allow you to make periodic optional cash purchases of stock, usually (but not necessarily) commission-free, although there are often constraints on such purchases (e.g., minimum purchase requirements). Given that the dividends or optional cash purchase amounts are unlikely to be an exact multiple of the stock price, it is typical to get fractional shares of the stock. For example, if you have $187.50 in dividends to reinvest and the stock price is $75 per share, you would get an extra 2.5 shares (assuming no fees). That might look a bit strange, but shares do not have to be whole numbers.
An alternative way to automatically reinvest dividends is to create a synthetic DRIP through a brokerage. If the dividend-paying stocks are held in a brokerage account, some (but not all) brokerages provide the option to automatically reinvest your dividends for free. You should check whether your brokerage has this option. A synthetic DRIP can be more convenient than a company DRIP because you can do it all within a single brokerage account. However, you would not get any price discount that may be associated with the company DRIP and any optional cash purchases would be equivalent to regular stock purchases, so brokerage commissions would be charged.
The main advantage of automatic dividend reinvestment is that it can usually be done for free. The main disadvantage of the method is that because it is automatic, you might be reinvesting dividends in a stock that is overvalued, which may not be the most effective use of that money. That is, you probably would not make a regular stock purchase (with new capital) of a stock that is overvalued, so you probably would not want to see your dividends used to buy overvalued stocks. Synthetic DRIPs do provide the option of temporarily turning off automatic dividend reinvestment and collecting your dividends as cash, in which case you could do selective dividend reinvestment. You can also turn off company DRIPs, but you would have to transfer the cash out of the DRIPs in order to selectively reinvest it.
Selective dividend reinvestment involves actively reinvesting dividends into stocks you select. The dividends are collected in your brokerage account as cash and can be reinvested into any stock in your portfolio (not necessarily the stock of the company that paid them) or you can use them to start new positions. Nothing is done automatically, so you have complete control over when and in which stocks the dividends get reinvested.
The main advantage of selective dividend reinvestment is the control over stock selection. If one of your stocks is overvalued, you do not have to reinvest your dividends in it. Instead, you can reinvest the dividends in an undervalued stock, which may be a more effective use of that money. For example, if you have two dividend-paying stocks that start with similar yields, but then one becomes overvalued due to its stock price increasing (lowering its yield) and the other becomes undervalued due to its stock price decreasing (raising its yield), and nothing else changes (e.g., the dividend rates remain the same), then you will find that reinvesting the dividends from both stocks in the undervalued stock will provide a larger boost to your dividend income compared with reinvesting the dividends in the respective stocks that paid them. That is what I mean when I say that selective dividend reinvestment may be "more effective." The main disadvantage of the method is that dividend reinvestment would be equivalent to a regular stock purchase, incurring brokerage commissions. Investors generally want to minimize such transaction costs because they reduce overall return.
The two methods have complementary advantages and disadvantages, so I do not think one is necessarily better than the other. I think both methods are sensible approaches to dividend reinvestment and the method an investor chooses will depend on his or her individual circumstances. In fact, one does not even need to choose between them; there are investors who have some stocks in DRIPs and selectively reinvest the dividends from other stocks.
Why do I choose to selectively reinvest dividends? The reason is that the main disadvantage of the method -- incurring brokerage commissions -- is a moot issue for me because I buy stocks with new capital on a regular basis (see my Transactions page). Regardless of how I choose to reinvest my dividends, I will always have to pay a brokerage commission when I buy a stock with new capital. Thus, if I selectively reinvest my dividends by combining them with new capital to buy a stock, I do not incur any brokerage commission over and above what I would have to pay anyway for buying a stock solely with new capital. From this perspective, the main disadvantage of selective dividend reinvestment goes away. Moreover, I would still get the main advantage of the method because the dividends would be reinvested in undervalued (or fairly valued) stocks, which is what I typically try to buy with new capital.
I think this approach makes sense and works well for me, but as mentioned above, it may not be suitable for all investors. For example, a retiree or someone who is not investing much new capital would probably be better off doing automatic dividend reinvestment to avoid paying commissions. However, young investors like me may benefit more from selective dividend reinvestment. Regardless of which method you prefer, I think it is a good idea to reinvest your dividends if you do not need them right now to supplement your other income. As discussed on my Strategy page, dividend reinvestment is a key element of the long-term compounding involved in creating a rising dividend income stream, so it can be very beneficial to put that money to work for you.