This article was last updated on June 30
I have received a lot of good and bad financial advice over the last few years and it is hard to categorize which advice was the best. However, one piece of advice that does come to mind and which I received early in my investing days, is to ensure I reinvested my dividends rather than fritter them on unnecessary expenses. When I first started received dividends I used to think of it as “bonus” money, that I wasn’t expecting and so used to just spend it. However, as I matured in my investing habits and on the advice I received from a number of more experienced investors, I soon realized why dividends were important and how they could be used to boost my wealth by automatically reinvesting them through dividend reinvestment plans.
Dividend Reinvestment plans (DRIPs) are not a new concept and have been around since the 1960’s. Unfortunately less than 50% of all investors take advantage of these types of programs when available to them. DRIPs are offered by companies to their shareholders as a way to buy stock directly from the company (usually through a transfer agent) in small or large amounts, and sometimes at a discount to the current market price. The plans allow stockholders to directly reinvest all or partial dividends paid into more stock (equity), thus the name “Dividend Reinvestment Plan.” Even though they don’t receive the cash, investor’s must still pay tax on their dividend income.
DRIPs are a cost effective way of raising equity for companies and beneficial for investors in that it allows the investment return from dividends to be immediately invested for the purpose of price appreciation and compounding, without incurring brokerage fees or waiting to accumulate enough cash for a full share of stock.
Advantages of DRIPs
– Enables investors to cost effectively take advantage of dollar cost averaging with dividend income that the company is paying out. Not only is the investor guaranteed the return of whatever the dividend yield is, but he or she may also earn whatever the stock appreciates to during their time of ownership. Off course, the investor is also subject to whatever the stock may decline to, as well.
– You don’t need a large amount of money to start. You can participate in a DRIP with as little as one share of stock. Check with your broker or the company’s website (investor section) to get more details on dividend reinvesting plans offered.
– Allows you to grow your investment capital by purchasing more shares of the company rather than simply spending the money or having it sit in a money-market account.
– Most company offered DRIPs have no transaction, brokerage or account keeping fees. So you are getting 100% of your returns invested.
– Some companyoffered DRIPs allow investors to purchase stock, bought from the reinvested dividend income, at a discount to the current market price. These discounts can range anywhere from one to ten percent and gives investors an immediate return on their investment.
– DRIPs “force” investors to buy stock on a regular basis and hold on to that stock. As a result, investors adopt a long-term horizon and often invest small amounts of money on a regular basis – money that they usually don’t even miss.
Disadvantages of DRIPS
– Administrative hassle. A downside of using DRIPs is that the investor must keep track of cost basis (for tax reasons) of many small purchases of stock, and maintain records of these purchases. This record keeping can become burdensome (or costly, if done by an accountant) if the investor participates in more than one DRIP for many years. For example, participating in 15 DRIPs for ten years, with all of the stocks paying quarterly dividends, would result in at least 615 share lots to keep track of—the 15 initial purchases, plus 600 reinvested dividends. Further complications arise if the investor periodically buys or sells shares, or if the company is involved in an event requiring adjustments to cost basis, such as a spin-off or merger. However, a number of the leading brokerages now have systems in place that do all this tracking for you.
– You don’t choose the timing of when the stock is bought. The DRIP’s have specific schedules of when stocks are bought from the reinvested dividends, and the stock price may fall after it is purchased via the plan.
Overall, the advantages of DRIPs far outweigh the disadvantages so if you do not depend on dividends as a key income source and are a long term holder of the stock, then DRIPS are a no-brainer investment. You can also get out of a DRIP at any time, so treat them like any investment. If you feel that the companies long term prospects are not great then don’t participate in the DRIP plan (why then are you holding stock of the company?)
Over the years, I have found using DRIPs a very effective (and automatic) way to grow my capital in a given stock or fund without paying any transaction fees. A good analogy comes from a Motley fool article (which provided some background material for this post) that says “You’re re-investing dividends, but you’re also “dripping” money into your holdings every month, ideally. Drip… drip… drip…. And that adds up over time”.
DRIP’s allow you to harness the benefits of dollar cost averaging and compounding to boost your returns over the long term. If you are holding onto a dividend paying stock for the long term, sign up for the DRIP today! That is the advice I received and am now passing on to you.
** As a side, side note. when writing this post, I got confused if the word I should be using is Advise or Advice. Here is the clarification: “Advice” is the noun, “advise” the verb. When a teacher advises people, she gives them advice.