As a investor in dividend paying stocks, it is important to leverage the tools available to you in order to maximize your return on investment. There are many financial ratios like the dividend yield, yield on cost, and payout ratio that are used by investors to make educated investment decisions. There is also another kind of tool that can help income investors lower their costs and build a solid portfolio over time – DRIP investing.
Setting up a dividend reinvestment plan or DRIP provides a way for investors to slowly grow their money. Also referred to as a DRP, this tool can help limit expenses paid to a broker while reinvesting all dividends back into the same stock.
Let’s take a closer look at what a DRIP is and how it can help the average investor.
What is a DRIP?
According to Investopedia, a DRIP is “A plan offered by a corporation that allows investors to reinvest their cash dividends by purchasing additional shares or fractional shares on the dividend payment date.”
For most dividend investors, setting up a DRIP is a great way to increase the value of their investment with no action required. Depending on the stock and/or the brokerage firm, most dividend reinvestment plans allow the investor to purchase shares with no commission or fees. This can drastically cut down on expenses that are often required to build and maintain a profitable portfolio of dividend stocks.
Types of Dividend Reinvestment Plans
Believe it or not, there are a couple different types of dividend reinvestment plans available. One allows the investor to purchase stock directly through the company, while the other requires a third party to invest.
Here are two popular methods for DRIP investing.
- Company Managed – There are several companies that actually run their own dividend reinvestment plans. These companies usually allow the investor to buy shares of their company directly through them without a broker. They also allow investors to buy partial shares, which can be a great way to invest if you don’t have a lot of capital to start with. Popular companies like McDonald’s Corporation and Procter & Gamble are just a few of the many publicly traded companies offering this service.
- Brokerage Account – Most online discount brokerages allow their customers to reinvest their earned dividend back into the stock at no cost. The incentive for the broker is to keep it’s current clients by offering this feature while the investor gets a discount on the expenses they will have to pay. Setting up a DRIP through an online broker usually takes just a few minutes to complete, making it an easy to use investment tool.
Advantages of DRIP Investing
Many successful income investors use dividend reinvestment plans on at least a few stocks in their portfolio. A DRIP is generally easy to setup, which makes them a popular feature for investors.
Here are a few other advantages to DRIP investing –
- Purchase Fractional Shares – If an investor receives $20 from a dividend payment and the share price of the stock is $40, a DRIP makes it possible to purchase .5 shares. This allows the investor to continue to build their position by reinvesting all of their dividend payment immediately back into the stock without having to wait to buy a full share.
- Automated Stock Purchase – These types of plans can be setup to automatically reinvest any dividend payments directly back into the stock. There is no action required by the investor making it a nice option for those of us with hectic lives. It generally takes less than 5 minutes to setup this feature with an online broker.
- Commission Free – A great thing about dividend reinvestment plans is that they generally don’t require any commission be paid. Most online brokers don’t charge any commission fees when an investor decides to reinvest their dividends back into shares of the stock. This is great for the investor as they can lower the overall costs and the broker who gets to hang onto a customer longer by offering this feature.
Disadvantages of DRIP Investing
Using DRIPs can help investors automate their dividend reinvestment’s while lowering the costs of commissions and other fees. There are plenty of advantages to setting up dividend reinvestment plans, but there are also a few disadvantages to consider.
Here are a few disadvantages of DRIP investing –
- Diversification – Setting up a DRIP for the long term can prevent an investor from having a diversified portfolio. It is critical for the investor to monitor stocks in their portfolio to ensure any dividends should automatically be reinvested.
- Initiating New Positions – Many investors use the income they generate from dividends to initiate a new position in their portfolio. Using a DRIP prevents this from happening as all the income is reinvested back into the same stocks, leaving no money to open positions in new stocks.
- Tax Tracking can be a Hassle. You need to keep excellent records of your transactions if you invest with DRIPs outside of a tax advantaged retirement account like a Roth IRA. Making multiple stock purchases each year can give you very different cost basis for each lot of stocks you own. You can alleviate this hassle by investing in an IRA or other tax advantaged account, by using a brokerage such as TradeKing, that offers tax management software, or by keeping excellent records.
Experienced and successful dividend investors know how to use dividend reinvestment plans to their advantage. In some cases, it makes sense to setup one of these plans to help build a position in a new dividend paying stock. There are other times when setting up a DRIP just doesn’t make sense. The key is understanding when to use DRIPs and when to leave them alone and manage the dividends yourself.
Do you DRIP? What tips can you provide other investors on setting up dividend reinvestment plans?