Everything You Need to Know about DRIP Investing
Dividend reinvestment is an appealing strategy that can enhance your investment returns. With this approach, you reinvest the dividends received into purchasing additional shares of the company or fund that issued the dividend, typically at the time the dividend is paid. Over time, dividend reinvestment facilitates the compounding of gains by acquiring more stock and mitigating risk through dollar-cost averaging.
For instance, as reported by Dividend.com, an initial $2,000 investment in Pepsi in 1980 would have initially provided an investor with 80 shares. Through dividend reinvestment, those shares would have multiplied to an impressive 2,800 by 2004, with a value exceeding $150,000.
Let’s delve into what dividend reinvestment entails, how it operates, and the advantages and disadvantages associated with this strategy.
What is dividend reinvestment?
Dividend reinvestment involves redirecting the dividends you earn back into your investments instead of cashing them out. There are two primary methods for reinvesting your dividends:
- Establish a dividend reinvestment plan (DRIP) directly with the company.
- Utilize your brokerage account to reinvest your dividends.
What is a DRIP program?
Numerous publicly traded companies offer dividend reinvestment plans (DRIPs), which automatically reinvest the company’s dividends into new shares of its stock during each quarterly dividend payout. These programs, aptly named after their acronym, operate at no ongoing cost to investors and enable the direct purchase of shares from the company, bypassing the need for a broker.
Chuck Carlson, the editor of the DRIP Investor newsletter, notes, “For certain investors, especially those just starting their investment journey and seeking an accessible pathway to investing in individual stocks, DRIPs hold appeal.”
Some companies provide flexible DRIP options, allowing for full or partial reinvestment. Investors seeking a steady stream of income can choose to have a portion of dividends deposited into their checking or savings accounts instead of reinvesting them entirely.
Additionally, many companies permit the purchase of fractional shares through DRIPs, enabling investors to reinvest their entire dividend into new stock, thereby compounding their gains. Furthermore, certain companies offer DRIP shares at a discounted price compared to the current market value, providing investors with a more favorable price than they would obtain through open market purchases.
Dividend reinvestment with a broker
While dividend reinvestment remains a proven strategy, investors now have more convenient and cost-effective options than registering with a company’s DRIP program. Many brokerages offer this service for free, and with major online brokerages providing unlimited free trades, investors can easily reinvest their dividends themselves.
When reinvesting dividends through your brokerage, you can arrange for automatic reinvestment in shares of the company or fund that issued the dividend. This approach is particularly beneficial if your broker allows reinvestment in fractional shares, as it enables you to maximize the utilization of your funds.
Alternatively, you can opt to leave the cash in your brokerage account and manually reinvest it in stocks that appear attractive to you at the time. Regardless of the method chosen, the dividends are being reinvested to enhance your investment portfolio.
Cash vs. reinvested dividends
When you receive dividends, you essentially have three primary options:
- Keep the dividend as cash.
- Utilize the dividend for spending purposes.
- Reinvest the dividend.
Holding the dividend as cash or spending it is acceptable if you require the income, particularly for retirees and others seeking to generate income from dividend stocks. However, by opting for these choices, you miss out on the benefits of dividend reinvestment and compounding.
By reinvesting dividends in a growing dividend-paying company, you stand to benefit in two significant ways. Firstly, you may profit from any increase in the stock price since you’ve expanded your ownership through additional shares. Secondly, successful companies typically raise their dividends over time, resulting in increased dividend payments per share. Consequently, you’ll own more shares, each generating higher dividends, thus enabling you to acquire even more shares and continue the cycle.
Dividend reinvestment can initiate a virtuous cycle, creating a potent dividend generator for your investment portfolio.
Pros and cons of dividend reinvestment
Dividend reinvestment shares many advantages and disadvantages with regular investing but also brings forth its own unique set of pros and cons.
Advantages of dividend reinvestment
- Enjoy compounded gains: Continuously growing stock values can lead to compounded gains as you reinvest dividends into the stock.
- Set-and-forget convenience: By automating dividend reinvestment through your account, you eliminate the need for manual intervention. These plans typically continue until you opt to terminate them.
- Simple setup: Both DRIP plans and reinvestment options through your brokerage are straightforward to establish and oversee.
- Avoid trading fees: Automatic dividend reinvestment may allow you to bypass trading fees, particularly at mutual funds.
- Lower risk via dollar-cost averaging: Consistent reinvestment over time facilitates dollar-cost averaging, reducing investment risk.
- Flexibility to adjust: You can pause or terminate reinvestment plans if you require cash, or modify them to suit your preferences. Additionally, DRIPs may offer options for full or partial reinvestment.
- Opportunity for discounted stock purchase: Some DRIP plans might provide the opportunity to purchase stock directly from the company at a discounted rate.
- Non-digital investment avenue: DRIPs can serve as an alternative investment avenue for individuals hesitant to invest online, catering to those more comfortable with traditional mail-based methods.
Disadvantages of dividend reinvestment
- Minimum requirements: Although DRIPs aim to assist small investors, some companies may impose minimum share thresholds to participate in the plan.
- Plan variations: Given the substantial variations among DRIPs, it’s crucial to contact the company directly to understand the specifics of its plan. Some companies might necessitate a one-time setup fee for an account. Information on the plan can typically be obtained from the company’s investor relations department, enabling you to assess its suitability for your needs.
- Limited investment scope: DRIPs exclusively invest in their own stock or fund, meaning investors seeking to use dividend payments to purchase different stocks must do so independently.
- Rigid reinvestment schedule: DRIPs and reinvestment options through brokers typically reinvest dividends at the time of payment, offering investors limited flexibility regarding reinvestment timing. Consequently, there may be missed opportunities for potentially more profitable investments elsewhere.
- Potential portfolio imbalance: Holding dividend-paying stocks alongside non-dividend-paying ones may result in disproportionately large positions in dividend stocks, potentially undermining portfolio diversification and increasing reliance on these holdings.
- Tax implications: Although you may reinvest the entirety of your dividend, taxes on the income must still be paid, necessitating funds from your pocket to cover the tax liability.
Are DRIPS a good investment?
Given the inflexibility inherent in DRIP plans and the flexibility and affordability of brokerages today, many experts no longer view DRIP plans in the same favorable light as before.
“The primary benefit of a DRIP that I see is the establishment of a regular reinvestment program for cash distributions,” notes Stephen Taddie, partner at wealth manager HoyleCohen in Phoenix.
Regular investing is crucial, not only to prevent cash from idling in the account but also to leverage dollar-cost averaging, thereby mitigating risk by spreading stock purchases over time. Additionally, automating financial decisions can be advantageous.
“People should automate as many financial decisions as possible,” says Robert R. Johnson, professor of finance at Creighton University. “Automatic enrollment in a DRIP capitalizes on people’s inertia and inherent laziness.”
Taddie emphasizes that DRIPs were more appealing when transaction commissions were significantly higher, particularly before the era of online brokers.
However, Taddie highlights a drawback of traditional “set it and forget it” dividend reinvestment: the presumption that one would want to purchase the stock precisely when the dividend is paid, as typically dictated by companies and brokers.
“The more volatile the stock price, the less inclined I am to let the calendar dictate when to invest more money in a company,” he explains.
Alternatively, investors may opt to accumulate cash from quarterly dividends and invest it in a stock that is attractively priced at their discretion, rather than being constrained by the reinvestment plan’s timing. This approach allows for diversification and the opportunity to invest in assets with varying risk-return profiles, which is not feasible with DRIPs limited to purchasing the company’s stock.
Getting started with dividend reinvestment
To initiate dividend reinvestment, you’ll first need to determine the type of reinvestment plan you prefer:
- If you opt for brokerage-based reinvestment, you’ll have the flexibility to reinvest in both stocks and funds that distribute dividends. Many brokerages also facilitate investment in fractional shares.
- On the other hand, if you choose to utilize a company’s DRIP plan, you’ll be limited to investing and reinvesting solely in that specific company’s stock.
Each brokerage platform features its unique procedure for establishing dividend reinvestment, necessitating reference to the broker’s help resources or customer support for initiation. Typically, the entire process can be swiftly completed online.
To commence a DRIP account directly with an individual company, you can reach out to the company’s investor relations department. If the company lacks a DRIP program but issues dividends, you can still arrange a reinvestment plan through your brokerage account.
Do you have to pay taxes if you reinvest dividends?
Whether you opt to receive your dividend as cash or reinvest it in stock, you’re still responsible for paying taxes on that income. While this may not pose a significant issue if you receive a modest amount of dividends annually, it can become challenging if you’re receiving substantial dividends and reinvesting all of them into stock. In such cases, you’ll need to find the funds to cover the tax liability from other accounts to sustain your dividend reinvestment strategy.
To address this issue, some advisors may suggest housing dividend-paying stocks in a tax-advantaged account like an IRA. This approach helps mitigate taxes on the dividends, allowing them to compound over time without the burden of immediate taxation.
In Conclusion
The cost advantages once associated with a DRIP set up directly through a company are not as significant as they used to be, leading individuals seeking to reinvest dividends to typically favor their brokerage accounts. However, if a company’s DRIP plan offers the opportunity to purchase stock at a discount compared to its market value, this can serve as an appealing incentive.