A number of companies offer their investors the opportunity to enroll in a dividend reinvestment plan, otherwise known as a DRIP. There are a number of reasons to join a DRIP if given the option, though it is not the right move for every investor. Read on for a brief overview of DRIP, along with an explanation of some of its benefits and disadvantages.
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What Is a DRIP?
A dividend reinvestment plan uses the monies earned from dividend payouts to automatically purchase additional shares of the same company or fund. In other words, the windfall investors earn from their dividends gets plowed back into the same investment.
Dividends are payments that companies and funds pay their shareholders, usually on a quarterly basis. They provide shareholders with a portion of company profits, and can come in the form of cash payments or additional stocks through a DRIP option.
DRIP can be thought of as a form of dollar-cost averaging investing, whereby investors invest a specific amount of money into a stock or holding at regular intervals. Dollar-cost averaging allows investors to avoid some of the risks of market volatility, by spreading out investments at various price points over time.
How Can I Start Investing with DRIP?
Companies offering a DRIP option tend to make this available only for their existing shareholders, so to start investing via this method you first need to purchase shares in companies who offer this function.
Enrolling in a company-operated DRIP program will mean that your dividend payments will automatically go towards purchasing new shares. Some companies will even allow you to purchase portions of stocks if your dividend payments are not sufficient to acquire a complete share.
If the company you are invested in does not offer a DRIP, you could also adhere to this philosophy by using your dividend payments to independently purchase additional stocks. This would give you the benefit of dollar-cost averaging. However, you would be responsible for paying the brokerage fees you avoid by being enrolled in a formal DRIP program.
What Are the Advantages of DRIP?
There are a number of advantages of DRIP for investors. Reinvesting your earnings allows these monies to keep growing in value, as opposed being used for consumption or sitting in a low-earning savings or checking account.
These DRIP programs promote the continuous reinvestment of capital, allowing investors to enjoy the benefits of compound interest. Your earnings begins to reap new earnings, allowing for your wealth to start growing at increasingly rapid rates. The TipRanks’ dividend calculator allows you to calculate your returns both with DRIP and without, helping you understand how this works and the monetary benefits of this practice.
In addition, some companies sell their shares through DRIP programs at discounted rates, allowing shareholders to gain more from their monies. The avoidance of brokers’ fees is also an advantage, as company-administered programs will execute these transactions automatically, saving money on the backend as well.
What Are the Disadvantages of DRIP?
There are two principle disadvantages of following the DRIP investment strategy, both in terms of added costs and decreased autonomy.
Similarly to dollar-cost averaging, making investments through automatic and regular intervals could mean purchasing stocks at inopportune times. In other words, adhering to this investment approach means that there will likely be situations where you will be purchasing additional stock when the market considers it overvalued. In theory, though, this will balance itself out over the long-term (there will also likely be times when you purchase the stock when it is undervalued).
The second disadvantage is that you will be responsible for paying for taxes on your dividend earnings, even if you are directly reinvesting them. In other words, you will need to find funds from other sources to pay for these tax obligations, as the money you have earned from the dividends is being devoted to purchasing additional company shares.
Conclusion: Building Your Wealth Through DRIP
DRIP will allow you to continue to reinvest your earnings, growing your wealth as you continue to pour your gains into your portfolio. In this sense, it can serve as a good pathway towards ensuring that you are investing your funds instead of spending them or having them sit idly in a low-interest account.
Some investors, however, might prefer to have more flexibility with their investments, and look for alternative options for their funds. For these individuals, DRIP might not make the most sense.
At the end of the day, everyone shares the same investment objective: to earn money by safeguarding and growing their wealth. DRIP is one option to help you do just that.
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