Dividends are an important way investors create cash flow from their investments without having to sell off their shares. However, what do you do with your quarterly payout? Do you use it? Reinvest in other assets? Or, put it back into the company to help you earn even more? Many people choose this last option and set up a DRIP investment. If you’re considering option number three, here’s what you need to know.
What Is a DRIP Investment?
A DRIP investment, or dividend reinvestment plan, is a popular strategy where you use your dividends to purchase more of a company’s stock. As the name suggests, it drips your earnings into additional shares, slowly adding to your returns.
Each quarter when companies pay dividends to their shareholders, those with a DRIP investment buy more shares with their earnings. When you opt into the plan, it automatically reinvests your dividends every quarter as part of the dollar-cost averaging approach. By making consistent investments at regular intervals, it lowers the average cost of the company’s shares over time.
Investors also have a better purchasing position since they can buy fractional shares as well. Since you can roll over the full amount of dividends into new stock, it compounds your gains and puts all your money to work for you.
If you want to set up a DRIP investment, you can buy them directly from the company or through a brokerage. As an added incentive, reinvestment plans sometimes offer additional shares for a significant discount.
What Are the Pros and Cons?
Every investment strategy comes with pros and cons. Here’s what you should keep in mind when you are considering a reinvestment plan.
1. It gives you compounding gains.
When a stock consistently brings good returns, its value will continue to increase over time. As your dividends increase, you have more to reinvest back into the company, which will pay out even higher dividends.
With a DRIP investment, the cycle of profit continues and you earn higher returns every quarter by owning more shares. Thanks to compounding gains, your initial investment has the potential for unlimited growth.
2. ADDITIONAL SHARES COME AT A DISCOUNT.
Another advantage you get with a DRIP investment is discounted share prices. Instead of paying the open market price, the company will usually offer a reduced price when you reinvest your dividends. The discount can be anywhere from 1-10% which helps you get more for your money.
3. A DRIP investment reduces your risk through dollar-cost averaging.
Banking on the technique of dollar-cost averaging, a DRIP investment reduces your risk and exposure to price fluctuations. When you buy shares at regular intervals, you are not buying them at their peak or lowest price. And since you get the shares at a discount, this lowers the average price to save you money.
4. Investors increase their position with no additional fees.
Since investors can purchase shares for up to a 10% discount, a DRIP can increase your purchasing position. When you buy shares below the market value, can buy more shares in the company and set yourself up for even greater dividends.
Plus, they usually come with zero commission and brokerage fees. Unlike other investment options, you can avoid trading fees to free up even more money for reinvestment.
5. DRIP INVESTMENTS TAKE AN AUTOMATIC APPROACH.
Most investments require careful monitoring and adjustments based on market fluctuations. But, this is one of the few investments where you can set it and forget it. It continues making regular investments until you decide to stop. Not only does this prevent you from rash decision-making during downturns, but it also keeps you focused on your long-term goals.
6. IT’S EASY TO SET UP AND MANAGE.
It’s really very simple to set up a DRIP investment. Once you enroll in the plan, your work is done. It automatically reinvests your dividends so you don’t even have to think about it. The plan remains in place indefinitely and requires little oversight since it purchases the shares with no consideration of the market price.
1. Plans vary between companies.
Although the structure of a DRIP investment is universal, the plans may vary between companies. For example, they may charge a one-time setup fee or offer different discounted rates when you buy additional shares. To find the details of a particular company’s stock, you should contact their Investor Relations department to learn more.
2. It limits your investing options.
When you sign up, DRIPs will automatically reinvest your dividends for you. However, they will only use it for their stock. If you have other ideas for investing your dividends, then this isn’t the right product for you.
3. A DRIP may have minimums.
As mentioned above, every plan is different. Before you sign up, find out if they require you to purchase a minimum number of shares to participate.
4. It comes with a restrictive reinvestment schedule.
With most brokerage accounts, you have the option to buy stock whenever the mood strikes. However, a DRIP only reinvests dividends when they are paid out. And since this is done automatically, there is no consideration for market conditions. If shares are high, it could end up costing you more to reinvest with the same company.
5. It could create an unbalanced portfolio.
If some of your stocks are paying dividends while others aren’t, a DRIP could lead to an imbalance in your holdings. While this reinvestment strategy has many benefits, an unbalanced portfolio reduces diversification and makes you more reliant on the stocks you own more shares of. This overexposure could leave you vulnerable when market conditions change.
6. You still have to pay taxes on your dividends.
While you can reinvest the entire amount, you still have the tax burden of dividends. Even when you reinvest them, dividends are considered taxable income. If you don’t account for this, you may end up paying out of pocket later on.
How Do You Set Up a DRIP Investment?
Although some brokers prefer not to let a calendar dictate their investment strategy, establishing regular investing habits is good for your long-term financial plans. If you and your financial advisor believe this would be a good addition to your portfolio, it’s simple to set up a DRIP investment.
- Research which companies offer DRIPs. You can easily find this information online. However, some brokerages may set up their own DRIPs, even if the company doesn’t offer them publicly.
- Decide which stock to buy. Look into their dividends history to ensure they have a proven track record of profitable performance. It’s also a good idea to choose a stock that will help you maintain a balanced portfolio.
- Become a shareholder. Once you know what stock you want to buy, you have to become a shareholder. You have several purchase options. This can be done directly through the company, a brokerage, or your online brokerage account.
- Enroll in the DRIP. The easiest way is to facilitate it through a brokerage. If you use your online brokerage account, the site will usually include tutorials. However, if you choose to go directly through the company, you will have to enroll through their Investor Relations department or with a transfer agent.
- Watch your dividends grow. Once you’ve enrolled, the DRIP will automatically reinvest your dividends following each payout. It will continue to do so until you opt out of the program.
If you are a new investor, DRIP investments are a great way to grow your portfolio. However, if you plan to live off the dividends, it make not make sense for your investment strategy. As with all investments, you should always weigh the benefits and discuss them with your financial advisor to see if it’s the right choice for you.
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Jenny Smedra is an avid world traveler, ESL teacher, former archaeologist, and freelance writer. Choosing a life abroad had strengthened her commitment to finding ways to bring people together across language and cultural barriers. While most of her time is dedicated to either working with children, she also enjoys good friends, good food, and new adventures.