Dividend reinvestment is an attractive strategy that can juice your investment returns. With dividend reinvestment you buy more shares in the company or fund that paid the dividend, typically when the dividend is paid. Over time, dividend reinvestment can help you compound your gains by buying more stock and reducing your risk through dollar cost averaging.
Hundreds of publicly traded companies operate what are called dividend reinvestment plans, or DRIPs. Like the acronym, they drip the dividend into new shares of stock at each quarterly dividend payout. Companies typically run these programs without any ongoing cost to you.
While the strategy of dividend reinvestment remains time-tested, investors no longer need to register with a company’s DRIP program to reinvest their money. Many brokerages will do this for free, and with most major online brokerages offering unlimited free trades, you can simply reinvest the dividends yourself. Still, DRIPs do have benefits, especially for new investors who need to build their investing discipline at low cost.
What are DRIPs?
DRIPs are a program established by a company to allow investors to reinvest their dividends into shares of the company’s stock. The shares are purchased directly from the company, rather than through a broker.
“For certain investors, especially those just beginning the investment process and looking for an easy ‘gateway’ to invest in individual stocks, DRIPs offer appeal,” says Chuck Carlson, editor of DRIP Investor newsletter.
Often companies permit investors to purchase fractional shares, allowing them to roll their entire dividend into new stock and helping to compound their gains.
“For example, Amazon trades for more than $2,000 per share,” says Carlson. “However, via Amazon’s DRIP, you can buy the stock basically on the installment plan by investing to buy fractional shares of the stock.” He notes that Amazon’s DRIP requires an initial $250 investment but that subsequent purchases can be made with as little as $20.
While DRIPs are designed to help small investors, the companies may require a minimum number of shares to participate in the plan. Investors may also be able to contribute cash into the plan and buy shares directly from the company, bypassing the brokerage.
DRIPs may also be valuable for those who won’t invest using an online broker. “There is still an investor populace that is uncomfortable investing online and would rather do it via the mail,” says Carlson. “DRIPs offer a way for those folks to invest.”
DRIPs also allow flexibility. If you want to invest only a portion of your dividend and receive the rest as cash to spend or to pay taxes, then you may be able to set up your plan that way.
Because DRIPs may vary substantially, it’s important to contact the company to find out the specifics of its plan. For example, some companies may require a one-time fee to set up the account. A company’s investor relations department will have info on the plan, and then you can determine whether it meets your needs.
Are DRIPS a good investment?
“The only benefit from a DRIP that I can see is you establish a regular reinvestment program for cash distributions,” says Stephen Taddie, managing partner at Stellar Capital Management.
Investing regularly is important, and not only because reinvesting keeps cash from sitting idle in the account. Reinvesting also allows you to take advantage of dollar-cost averaging, reducing your risk by purchasing stock over time. Plus, you can turn your laziness into an advantage.
“People should try and automate as many financial decisions as they can,” says Robert R. Johnson, professor of finance at Creighton University. “If we are automatically enrolled in a DRIP, inertia and the inherent laziness of people tend to work in our favor.”
But even if you don’t opt for a company’s DRIP program, you can have a broker buy shares or fractional shares with your dividends. (Of course, you’ll still owe taxes on those dividends.)
“DRIPs made sense when transaction commissions were at cripplingly high levels,” says Taddie. Taddie gestures to the days before online brokers, when brokers charged much more.
“It is hard to imagine $300-$400 transaction fees for round lots… but that is the world that created the allure of DRIP programs. It was a cost-saving mechanism,” he says.
Taddies notes another issue with traditional “set it and forget it” dividend reinvesting — the assumption that you’ll want to buy the stock exactly when the dividend is paid, the traditional time that companies and brokers reinvest dividends.
“The more volatile the price of the stock, the less interested I am in letting the calendar mandate when to invest more money in a company,” he says.
DRIPs have other downsides, too
A portfolio built up over time may have numerous stocks and funds generating dividends. So with investors receiving cash streams from many investments, each of which has a valuation that may be more or less attractive, investors may not want to reinvest in a particular investment at a specific moment.
“The combined cash flow received from a quarter’s worth of dividends could be used to buy one of those stocks whose price is the most attractive, or, to increase diversification and add another good quality stock,” says Taddie.
Of course, investors might opt to hold the cash until a better opportunity comes along, too.
And reinvesting may be suboptimal for those who need the income for daily expenses, such as retirees, says Jeffrey Stoffer, owner and portfolio manager at Stoffer Wealth Advisors.
In addition, a retiree may have a large capital gain after years of investing and prefer to avoid a tax liability. Such a portfolio might be unbalanced, with one or a few positions dominating the holdings.
“If this is an overweight position in the portfolio, the reinvestment of dividends can compound the problem,” says Stoffer. “If the investor takes the cash dividends, it provides liquidity to deploy elsewhere in the portfolio.”
“Having cash come into accounts can also make rebalancing the portfolio easier, providing funds to buy asset classes that have become underweight in the portfolio,” he says.
In this case, while the investor does want to reinvest the dividend, it may make more sense to reinvest it in a different asset with a different risk and return. And that’s not an option offered by DRIPs, where you can buy only the company’s stock.
A DRIP established at a company doesn’t offer the same cost benefits over a brokerage that it used to, so those looking to reinvest dividends are probably better off turning to their brokerage.
At a brokerage, not only can you buy more shares of the stock that paid the dividend — if you want, you can also purchase another more attractive investment with no trading commission. So you have the ultimate flexibility to shape your portfolio however you want it and invest as you see fit.
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