The Stock Investor’s Quick Start Bundle
One of these tools can help you efficiently maximize your stock investments over the long term.
It’s called a dividend reinvestment plan, also known as DRIP.
But is it right for your investments, your time horizon, and you overall?
Keep reading to find out.
What is Dividend Reinvestment?
A Dividend Reinvestment Plan, or “DRIP” for short, is an investment plan that automatically allows you to use your dividends to purchase additional shares in the company.
A quick refresher on dividends: Some companies pay dividends to their stockholders on a quarterly basis. These are most likely going to be well-established companies, because new companies will likely use that extra capital to reinvest it in the business.
The dividend a company pays can either be shown as a percentage or as a dollar amount.
You can utilize DRIP:
- when you initially purchase the shares
- after you purchase them
If you will be in the markets for a long time, then you don’t really need the cash now. You would be reinvesting the dividends anyways, so using DRIP allows you to automatically do that.
Dividend Reinvestment Example
For example, let’s say the company pays a dividend of $0.10 each quarter and the company’s stock price is $25.00.
The dividend can either be quoted as $0.40 or as 1.60%.
We get the $0.40 because we need to annualize the quarterly amount. Then we can take this amount and divide it by the stock price of $25.00 to get our percentage of 1.60%.
But how exactly does DRIP investing work? Let’s continue on with our example so we can see how a scenario would play out.
If you own 600 shares of the company at $25.00, your investment is worth $15,000.00.
But then, by the time the company declares a dividend of $0.10 per share, the price increases to $30.00.
You’d receive $60.00 that would automatically be reinvested back into the company’s stock at $30.00, giving you another 2 shares and bringing your total to 602 shares worth $18,060.00.
If you had elected not to reinvest your dividends, you would have received $60.00 in cash.
Your investment in the company would have been 600 shares at $30.00 each, for a total of $18,000.00.
While the total impact is still the same in either scenario, a dividend reinvestment approach allows you to automatically put the money back into the company you are investing in.
What would have happened if the stock price increased to only $28.00, instead of $30.00 as in our example?
Your dividend of $60.00 would have been able to purchase an additional 2.14 shares, bringing the total number of shares to 602.14.
Your investment then would have been worth $16,860.00.
Wait…Can you actually own part of a share?
Owning part of a share is also called owning a fractional share.
Most brokerage companies will allow you to have fractional shares when dividends are reinvested.
However, some do not. In this case, you would have been able to purchase 2 additional shares at $28.00 per share.
The remaining $4.00 would have then been distributed to you as cash.
This is what makes the dividend reinvestment strategy, or the DRIP meaning, so valuable. Every dollar that is paid out as a dividend is reinvested back into the company for you, even if there isn’t enough to buy an entire share.
There are several advantages and disadvantages to a dividend reinvestment plan.
Let’s start with the advantages before we move on to the disadvantages.
Investment Grows Faster Over Time
The first advantage is that your investment grows faster over time. When you reinvest your dividends, you are earning compounding growth.
Instead of taking the money and leaving it in cash, it is able to be reinvested so the money grows faster.
Efficient Way to Invest
Another advantage of DRIP is that it is an efficient way to invest. Again, you don’t have to remember to reinvest the dividends; it is done automatically for you.
The final advantage is that it lowers the commission cost you pay.
Commission is lower when you implement a dividend reinvestment strategy compared to purchasing the stocks after receiving the dividend.
The main disadvantage to DRIP investing is that you will still have to pay taxes on your dividends, even if they are automatically reinvested.
You will have to make sure to have the necessary cash to pay for the taxes.
If you don’t have the full amount in cash, you may have to end up selling some of the shares to be able to pay the tax bill.
The tax bill will range from 0%-20% depending on:
- your tax status
- how much taxable income you earned for the year
When Should You Reinvest Your Dividends?
You should reinvest your dividends when you are actively trying to increase the value of your portfolio and are not worried about cash.
You should start a dividend reinvestment plan as a way to increase your portfolio without having to do anything.
This will yield compound growth in your portfolio.
A dividend reinvestment strategy is an effective investing strategy if you have a long time horizon.
When Should You NOT Reinvest Your Dividends?
On the flip side, you should not utilize DRIP when you need extra cash on the side.
Additionally, if a stock is volatile, you may not want to utilize DRIP.
Also, if you do not plan on holding stock for the long term, DRIP will not be a strategy for you.
How to Set Up a Dividend Reinvestment Plan
You can set up a dividend reinvestment plan in a few ways. Once you buy a particular stock, there will be an option to reinvest your dividends. If this is something you plan on doing, then you will select the option for ‘Yes’.
Or, if you have already purchased the stock, there will still be a way to join in on a dividend reinvestment plan. Once you log in to view your portfolio and the list of stocks you own, there will be the same option to switch to reinvest the dividends.
Once this is selected, your dividends will automatically be reinvested the next time the company issues a dividend.
Alternatives to DRIP Investing
If you decide that a dividend reinvestment plan is not for you, there are some alternatives you can still get into.
Companies Who Don’t Declare Dividends
The first alternative is investing only in companies that do not declare any dividends. This way you don’t even have to worry about a dividend reinvestment strategy.
This can be a good strategy if you believe in companies that don’t pay their stockholders any dividends. Keep in mind that a company that reinvests all of its net income into the business can grow at a faster rate and therefore so will its stock price.
Investing in Cryptocurrency
Another alternative is to take the dividends and invest them in riskier assets, such as cryptocurrency. This allows you to keep the majority of your portfolio in the less risky, well-established companies, but still invest in the high risk, high reward assets.
Even if the risky assets don’t perform well or even lose value, that is only a small percentage of your portfolio that you are putting at stake. But if these assets do increase by a wide margin, this can yield good results for your portfolio.
The Bottom Line: DRIP
A dividend reinvestment strategy can be a very good one depending on how you invest and what your time horizon is.
DRIP is also simple to implement.
Even if you decide that a strategy centered on dividend reinvestment is not for you, there are still other strategies that you can take advantage of.
The key point is to be intentional with your stock investing by setting up your personal strategy — and sticking to it.