Reinvest dividends or not. Which is better?
When you buy a fund, you'll be prompted to choose whether to reinvest dividends (and capital gains) in the same fund or receive them in cash or deposited into a bank or money market account. Unless you need the dividends as income for retirement, you have to choose: reinvest or not? By reinvesting, you're able to continue to grow your share balance in the fund. Over the long term, the increased number of shares acts as a buffer against price declines. On the other hand, taking the dividends and putting them in cash also acts as a buffer for the portfolio against future price declines because of the increased cash percentage. Think of it this way: if your portfolio generates 2% in dividends annually and those dividends are going into cash, it means you increased your cash allocation without rebalancing.
Reinvesting dividends, say on a quarterly basis, also performs dollar cost averaging by buying four times across the year. Note that when the fund issues a dividend, its share price, or Net Asset Value (NAV) will decrease; however, if it was on a day when the market was up, the closing price might still show a gain. And, if the dividends were actually interest payments on bonds, that won't reduce the NAV. Most investors do reinvest the dividends, but again, it's your choice.
If you decide not to reinvest, you can use the dividends to grow another investment, or sub-allocation, without having to sell current investments because there is always a risk of selling at the wrong time. For example, you decide to add some international stock allocation, maybe 5% of your stock allocation. You could either sell some funds, taking a risk of selling at the wrong time, or buy up your international allocation with the dividends you receive every quarter. (BTW - I like this method because you dollar cost average your international allocation, removing the temptation to time the market).
Another example is not to reinvest in stocks when the market is very expensive, or in bonds when interest rates are rising. For someone a few years from retirement, just changing all funds to not reinvest dividends several years from retirement can be a helpful strategy to de-risk as you approach retirement. Post-retirement, if the dividends are not needed as income, then not re-investing dividends can be an easy way to grow an emergency fund.
A final thought. If you decide not to re-invest, then you take on the responsibility to do the right thing with them for the right purpose. Otherwise, they might build up in a low-yield settlement fund and not work for you.