Dividend Reinvestment Plans (DRIPs): How Do They Work?

If you prefer to invest in individual stocks, and you have or want to have a portfolio of high-quality stocks, a dividend reinvestment plan (DRIP) can be a smart strategy.

It can enable you to increase your position in blue-chip stocks, by steadily reinvesting the dividends you earn back into the same companies.

How do DRIPs work, and can they benefit your investing strategy?

How DRIPs Work

A DRIP is a program you participate in that automatically reinvests dividends earned back into the stock of the same companies that issued them.

Though the company pays dividends in cash, you can opt to have that cash reinvested back into the company’s stock.

DRIPs are typically offered directly by the companies you invest in.

Naturally, they’re only available for stock in companies that pay dividends on a regular basis. This is generally larger, better-known companies, with a well-established history of paying dividends.

Hundreds of large companies offer dividends, including many of the most recognizable companies in the country.

DRIPs offer these major advantages:

1. Increase your position steadily

By setting up a DRIP you’ll be automatically increasing your position in each company on an automatic basis.

If you have confidence that the companies you’re investing in are solid, long-term investments, this can be a way to build your position over many years.

2. Dollar-cost averaging

DRIPs allow you to gradually increase your investment in each company you participate in using the plan.

Dividends are typically paid on a quarterly basis, so you’ll be adding to your position in each company four times each year, and in small increments. Dollar-cost averaging – buying into an investment over an extended period of time – can produce superior investment returns.

Why?

This strategy eliminates the need to make a large, one-time investment, and potentially at a bad time.

Since you’ll be spreading out your investment through the DRIP, you’ll avoid that outcome.

3. Buying fractional shares

A fractional share is a position in a stock that is something less than the current market price of the stock.

For example, let’s say a stock you own has a current market value of $100, and pays an annual dividend of $3. Since you own 100 shares, your total investment is $10,000.

That position will pay $300 per year in dividends, or $75 per quarter. By using a DRIP, you’ll be purchasing three-quarters of a share of the same stock.

Use of a DRIP eliminates purchasing fractional shares as a problem.

4. Compound interest equivalent

In a real way:

A DRIP enables you to invest in a stock by getting a benefit similar to compound interest.

Let’s work an example to demonstrate the advantage. Using the same scenario above, you own 100 shares of a stock at $100, paying a $3 annual dividend. If you take the dividends in cash, you’ll receive $300 per year, or $9,000 over 30 years.

But if you reinvest the cash dividends to buy more stock, you’ll be getting 3% compounded over 30 years.

That will produce a total return of $14,271, or more than $5,000 higher than you simply take the dividends as cash and spend the money.

Fees

This is yet another advantage of participating in a DRIP.

As a way to encourage shareholders to buy more stock in companies, corporations typically enable DRIP participation free of charge.

There is generally no fee to set up a DRIP, and no commissions or fees to reinvest in company stock.

This makes DRIP investing a pure-play.

You’ll not only get the advantage of buying more stocks in strong companies, but you won’t be charged any fees that might reduce your overall returns on your investment.

Though it isn’t true across the board, some companies even allow DRIP participants to purchase stock with their dividends at a discount.

Depending on the company, the discount can range between 1% to 10% on the reinvested stock.

Pros

• It allows you to increase your investment in select companies without any effort on your part. The entire process is automated.
• There are no fees to purchase additional stock with your cash dividends.
• Discounts, if offered, make the additional stock purchases even more attractive.
• You can buy fractional shares, since companies offering DRIPs have no minimum purchase requirement.
• DRIPs are usually handled through the issuing company’s investor relations department, which will not only facilitate the purchase of stock with your cash dividends, but they may also enable you to eventually sell the stock with no commission or other fees.
• You can dollar cost average purchases of additional stock in the same companies you already own. This will enable you to spread out the purchase of your position in each company, minimizing making the entire investment at one time.
• Excellent strategy if you are a committed buy-and-hold investor, who prefers investing in a portfolio of individual stocks to mutual funds or exchange traded funds.

Cons

• DRIPs are not suitable for short-term investors or frequent traders.
• Not all companies offer DRIPs, so you’ll be limited in the number of companies you’ll hold stock in.
• DRIPs will not be suitable if you are investing for income, such as taking distributions in retirement. At that point, you may have no need or interest for reinvesting your dividends in company stock.
• You’ll need to hold stock directly through each individual company you own to participate in the DRIP for each. That may lead to having your money spread across many different custodians, rather than all in a single portfolio.
• Even if you reinvest your cash dividends in more company stock through a DRIP plan, the dividends will still be taxable. But since you’ll have reinvested the cash into more stock, you’ll need to pay the tax out of other more liquid accounts.

Comparison of DRIP vs. Online Brokerage

The advent of online investing, as well as the elimination of trading commissions by most major investment brokers have blurred the line between participating in DRIPs with individual companies and through brokerage firms.

Many investment brokers now offer a DRIP option with stock purchased in participating companies.

There’s no longer a need to go directly through the individual company to set up the DRIP.

Furthermore:

The elimination of trading fees has taken away the financial advantage of direct DRIP participation in companies.

Now you no longer need to pay fees, whether the DRIP is maintained by the investment broker or the individual company.

Most brokers are also now allowing investors to participate in the purchase of fractional shares, also at no additional fee.

If an investment broker offers a DRIP option where available, you can hold all the stocks you own on the same platform.

You’ll also be free to participate in other investments, the kind that don’t offer DRIPs.

This can include especially growth stocks, which either pay no dividends, or pay very small dividends and don’t offer a DRIP option.

Conclusion: Is DRIP Investing Right for You?

DRIPs are certainly an excellent option to have for certain investors.

For the most part, they’re best suited for self-directed investors, who prefer to create portfolios of individual stocks.

The investor must also necessarily be a long-term, buy-and-hold investor, who plans to hold onto individual stock positions for decades.

But once again:

As investment brokerages have expanded their menu of services, as well as the speed and ease in which they operate, you can set up DRIPs with stock you hold in your portfolio that make such plans available.

There’s no longer a need to purchase stock directly from companies, when you can achieve the same result with a diversified brokerage firm.