Stock investors have two main ways of making a profit – dividends and price appreciation. Dividends are regular payments a company makes to shareholders, typically quarterly, that allow them to share the company’s profits.
When you receive a dividend, you have a choice. You can opt to receive the dividend as cash, creating a steady stream of income, or you can use a Dividend Reinvestment Plan [DRIP] to automatically purchase more shares.
What is a DRIP?
A DRIP is an account- or investment-level setting that allows you to automatically purchase shares of the same stock with your dividend payment, rather than receiving cash. These plans allow you to purchase whole or fractional shares, ensuring every dollar of your dividend is invested.
DRIPs are a cornerstone of a long-term growth strategy and can be a wise option if you are in the process of accumulating wealth, rather than using your assets for income. These plans are available at most investment firms and are generally offered for both non-retirement brokerage accounts and retirement accounts, like IRAs.
How does a DRIP work?
A DRIP is very simple to understand, and it works by purchasing additional shares as soon as the dividend is paid. You’ll buy the new shares at the current market price each quarter and can save on trade commissions by purchasing automatically.
To illustrate how a DRIP works, consider the following two examples. In each, an investor owns 100 shares of Stock A, which pays a $0.50 per share dividend each quarter.
Example 1: Dividends Paid in Cash
The investor’s 100 shares generate a dividend of $50 ($0.50 per share multiplied by 100 shares). This money is deposited into their brokerage account as cash. Then, they have a choice. They can manually buy more shares of the same investment, buy something else, or withdraw the cash. If they choose to buy more shares of the same investment, they will need to enter the trade and may owe a commission, depending on account terms.
Example 2: Dividends Reinvested With a DRIP
The 100 shares generate a dividend of $50. Instead of being deposited into the account as cash, the dividend is used to buy more shares of the same company. If the stock price is $100, the DRIP will purchase 0.5 additional shares – bringing the total number of shares to 100.5. The next dividend payment will be based on the higher share amount, and the process continues to increase the number of shares owned each quarter.
Since DRIPs are automatic, the investor doesn’t have to place a manual trade to purchase more shares. Further, they generally do not owe trade commissions on the transaction.
The table below shows how a DRIP can grow the total number of shares each quarter over the course of a year. Assuming that the price of the stock remains stable at $100, the dividend payments each quarter also rise along with the number of shares owned.
Benefits and Considerations When Using a DRIP
A DRIP offers several key advantages if you are at a point in your life where you are focused on growing your wealth. However, there are also important considerations that you should take into account before implementing a reinvestment strategy.
Freedom From Trade Commissions
A DRIP allows you to avoid trade commissions on subsequent purchases of an investment. Across a diversified portfolio of many investments, the freedom from fees can add up quickly and support your account growth.
The Power of Compound Growth
By reinvesting dividends, you continually grow the number of shares you own of a particular investment. Then, your future dividends are calculated based on a higher number of shares, leading to higher dividend payments if all other factors remain constant. This is known as compound growth, and it is one of the most powerful methods to increase your net worth over time.
Automated Investing Is a Double-Edged Sword
A DRIP automates your investing strategy, saving you time spent manually placing trades. It also allows you to implement dollar-cost averaging – a strategy that helps reduce the risk of buying at a market peak. This works by purchasing shares at regular intervals, so you buy at different prices, which helps to “smooth” the average cost of your shares over time.
On the other hand, a DRIP uses your dividends to purchase more shares of the same investment, so you can become overweight in securities that pay high dividends. For example, consider an investor whose ideal portfolio is evenly divided between two stocks, one that pays high dividends and one that pays no dividend at all. A reinvestment plan would increase the size of the holding in the dividend-paying stock, while the shares of the other stock would remain stable. Over time, the portfolio becomes skewed toward the dividend paying stock if all other factors remain constant.
Dividends Aren’t Received in Cash, But Are Still Taxed
In a non-retirement account, most dividends are taxed as ordinary income in the year you receive them, even if you use the dividend to buy more shares of the same stock. This means you will need another source of funds to pay taxes on dividends you reinvest.
Is a DRIP right for you?
As with all investing decisions, the right choice for you depends on your personal situation and goals. If you are in the process of accumulating wealth, and are confident in your investment selections, a DRIP can save you both time and money. On the other hand, if you need dividend income from your investments to help fund your lifestyle, a DRIP may not be right for you.
An experienced financial advisor is a valuable partner in determining your goals, preferred allocation, and the investing decisions that can help you accomplish your objectives. The right advisor can help you determine if a DRIP is a wise strategy for your investments and put a reinvestment plan into place in your account.
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