A lot of companies pay dividends to their stockholders. If you’re one of those investors, you have a few options for using those dividends. You could receive them as cash or you can reinvest those dividends. In other words, you could re-use those dividend payments to purchase more company stock.
DRIP investing is when you take those dividends from a company and reinvest them back into that same company. You can either invest through a brokerage account or a company you choose to invest in (without a brokerage account). Either way, DRIP investing is a valuable opportunity to make money in the long-term.
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What is DRIP Investing?
A dividend reinvestment plan, or DRIP, is a program that reinvests the cash dividends that an investor receives from a company to buy more of the same stock. This cycle makes the company investment grow over time. The work DRIP is an acronym for the ‘dividend reinvestment plan.’ The name is indicative of how the program works.
DRIP investing automatically invests all of your dividends (without commission) into more shares of the same stock. This auto-renewal happens if you don’t have enough money for a full share. As the name indicates, the investments have a massive impact on the investor’s portfolio returns. DRIP investing can result in a much higher overall return.
Types of DRIP Investing
DRIP investing can seem complicated, but it’s not too hard to begin once you understand the different options you have. There are a few different types of dividend reinvestment plans out there. Here are the two most popular methods.
Some companies run their own DRIP programs. These plans typically allow their investors to purchase shares directly through the company without the use of a broker. This direct investment eliminates brokerage fees and commission and allows the investor to use the full amount of their dividends to reinvest.
A company-managed plan also allows investors to purchase partial shares. This is an excellent way to start your investment portfolio if you don’t have enough cash to start purchasing full shares. Investing in DRIP with the company itself may also be beneficial to take advantage of discounts. Sometimes, the company offers stock at a discount to the market price. These discounts are available only to shares purchased through DRIP.
I think the option to purchase partial shares is fine, but it comes with terms and conditions. The brokerage needs to pool the dividends of every investor who wants to reinvest in that particular stock. This pooling is how they can offer partial shares. In the unlikely case that the total dividends of all the broker’s clients don’t add up to the total price of one share, they may not be able to reinvest. Keep this in mind when trading small or thinly-traded stocks.
The second method for dividend reinvestment plans is to use a brokerage account. There are online discount brokerages that allow clients to reinvest their dividends into their stock with no brokerage fees or commission. This option is valuable for both the investor and the broker. The no-fee option saves the investor money and the brokerage gets to keep their current clients. The investor gets a discount on brokerage services while the brokerage keeps (and even gains) customers. Setting up your DRIP through an online brokerage is simple and usually available online.
Using a brokerage account has its benefits and drawbacks. On one hand, using a brokerage account for your DRIP doesn’t require you to pay commission and there are guarantees on the security of your money. On the other hand, you may not be able to take advantage of the valuable discounts you may get if you reinvest directly with your company of choice.
The Benefits of DRIP Investing
DRIP investing has significant benefits for long-term investors, reducing investment costs, and streamlining the investment process.
Stocks Purchased Through DRIP Do Not Require a Commission
Say you purchase stocks through a broker. If you get a $200 dividend payment from a stock you’ve invested in, and your broker charges a trading commission (for example, $9.99), you will only be able to keep about $190 to reinvest in the stock. With DRIP, you can reinvest the full $200. It may not sound like much, but if you use your broker every time you receive a dividend every quarter, this adds up to over $1,000 in brokerage fees after 30 years. Not only are you saving money on these fees, but you can reinvest that money as well. Over 30 years, $40 invested a year at a modest 6% annual return nets you over $3,100. So it’s worth it to save on commissions if you can.
DRIP Investing Allows You to Purchase Fractional Stock Shares
Regardless of share price, you will be able to put your entire dividend payment to work. For example, say you own 100 shares in a particular stock at $322 each. If you receive a dividend of $250 at the end of the quarter, you typically would not be able to purchase another share. However, with DRIP investing, you can put your entire dividend to work. You don’t have to wait until you accumulate the money you need to get the next 10 shares. This process makes investing far more efficient, especially in the long-term.
DRIP Investing Allows You to Take Advantage of Dollar-Cost Averaging
This investment strategy lets you spread out your stock purchases to reduce the impact of volatility. Using DRIP allows you to take advantage of low share prices. You can buy more shares and take advantage of high prices to buy fewer shares at higher prices. As time goes on, you’ll invest at a better average price, compared to simply getting the same number of shares in one big purchase.
The DRIP Process Is Automatic
With DRIP investing, the automated purchasing of shares gives you access to the best prices. This way, you don’t need to check which stocks pay out the best dividends or when. You won’t even need to calculate how many shares you can afford to purchase. By enrolling in a DRIP, your brokerage will do the hard work for you.
The Drawbacks of DRIP Investing
As with anything else, there are drawbacks to DRIP investing. Here are just a few.
Little to No Diversification
Setting up a DRIP long-term could prevent investors from diversifying their portfolios. One of the benefits of a DRIP is that you don’t need to monitor it to check its reinvestment in the same stock (since that happens automatically). However, all of your income reinvestment goes back into the same stocks. This automation effectively limits you to one stock with your DRIP. You may still need to monitor your other investments to make sure they’re working in concert with your DRIP.
You Give Up Freedom of Choice
If you have a lot of faith in your current stock of choice, that’s great. Doing a DRIP with that stock is a good idea. However, if you feel that your stock is overvalued after your quarterly dividend, you have no choice but to reinvest in that same stock. If you didn’t have a DRIP, you could reinvest that money into another, more attractively-priced stock.
You May Have to Pay Higher Taxes
When you receive a dividend payment from a stock you own, the dividend is, unfortunately, taxable income. These dividends may end up more highly taxed than ordinary income.
Although there are some drawbacks to DRIP investing, the benefits far outweigh the risks. DRIP investing doesn’t allow much flexibility in different stocks, but it does allow you to keep earning money on the same stock over time.
How To Get Started with DRIP Investing
Enrolling in a dividend reinvestment plan is a simple process. With an online brokerage, you can do it through the brokerage’s website in your account settings. When you enroll in DRIP, you can enroll all of your current and future investments or choose which ones to enroll. The reinvestments are typically complete within a few days of the date your company pays out dividends.
There are also companies with apps that can help you start with DRIP, such as Stash. These apps help users incrementally invest small amounts of money. Over time, those small amounts add up to substantial gains. Even better, these companies have promotions happening constantly. For example, Stash gives new users a free $5 to invest in whichever stock they choose. Taking advantage of these apps allows you to get into the investing world, one small step at a time.
Although there are some drawbacks to DRIP investing, it’s clear that it’s beneficial to try out DRIP investing at least once. It’s a valuable tool for investors who are looking to make money in the long-term.
DRIP investing is smart for those who plan to invest in stocks and hold those investments for the long term. It’s not for people who hold stocks for two to three years and then let them go. DRIP investing, as the name implies, takes time. But if you take the time, you can save on commission and compound your investments effectively.