One of the best ways to build an ever growing income stream from your stock investment is with a DRIP. Simply stated a DRIP is a Dividend Reinvestment Plan whereby dividend distributions from your stock holdings are reinvested to purchase additional shares. By taking advantage of this type of investment vehicle you gain numerous advantages over the long term by allowing time to compound your investment. Let’s take a closer look at DRIPs and some of their inherent advantages.
One of the greatest advantages a DRIP features, is the ability to purchase additional stock fee free. Typically, when you buy stock from any of the popular brokerage houses a commission is charged per transaction. When you receive a dividend distribution that is enrolled in a DRIP the cash received is automatically reinvested and additional shares are added to your account for free. We all know that even small fees can add up to a lot over a long term investment and anytime you can add additional shares to your account at no cost should be taken advantage of.
DRIPs have the ability to provide you with tremendous compounding returns over time. Essentially, a one time purchase can grow to be quite large over time as DRIPs enter you into a never ending growth cycle whereby dividends automatically purchase additional shares which in turn provide an even greater number of shares at the next dividend distribution date. For example, if you had $2,000 invested in Pepsi in 1980, that would be worth more than $150,000 by the end of 2004. You would have started with 80 shares, but by reinvesting dividends, you’d now have 2,800 shares (source: Dividend.com).
Another great benefit of reinvesting dividends is the ability to automate purchases. This ‘set it and forget it’ approach essentially takes the ‘financial noise’ out of the equation when trying to decide whether or not you should make a stock purchase. Too often we are bombarded with scary headlines about the stock market and the direction it is headed in. These “news” sources might convince you, at times, to not invest or reinvest your dividend distributions. By enrolling in a DRIP, the thought process is essentially removed from the equation as every dividend received is automatically used to purchase additional shares. By having this autopilot approach you are afforded the luxury of putting your dividend distribution to work immediately which, as mentioned above, simply affords you portfolio faster growth.
These days DRIPs are very flexible in nature. You have the choice of determining full or partial enrollment with each investment you make. Say, for instance, you’d like to grow your portfolio by adding additional shares but also are looking for some dividend spending cash with each distribution. Solution: Enroll in a partial DRIP whereby a portion of your dividends purchase additional shares while the rest are given to you as cash. It is fully up to you to decide. Some stock brokerages even allow a flexible DRIP whereby dividends received in one company can purchase shares in another. Typically, DRIPs can only be reinvested into shares of the company that paid them. Scottrade, for example offers this flexible DRIP program whereby dividend distributions of, say Coca Cola, can be used to purchase shares in Pepsi. This is a great way to add diversity within your dividend income portfolio.
Another great advantage of enrolling in a DRIP is the ability to receive discounts from the companies that are sending you the distributions. Many companies offer 5% or even 10% discounts on your share price if you choose to reinvest your distribution back into the company that paid them. Just think about all these money saving advantages DRIPs offer. You save money on purchase fees and you may also be offered a share price discount.
Dollar Cost Average
Finally, DRIPs also give you the benefit of dollar cost averaging your purchase price without adding any new money of your own. If you bought a stock that happened to lose value after your purchase date your next dividend distribution will automatically buy new shares at a lower price thus lowering your average cost of the position.
One final note to be aware of when looking at different DRIP programs that exist is the ability to purchase whole or fractional shares. Most regular DRIP programs allow for the purchase of fractional shares which simply means that even the smallest dividend distributions can be reinvested even if the dividend received is not enough to buy one whole share. In this manner you are able to buy half, quarter or even tenths of a share of stock allowing your compounding machine to work with any dividend amount.
Other DRIP programs that exist are known as synthetic DRIPs whereby only whole shares can be purchased at a time. The disadvantage of these types of DRIPs is the fact that more money is needed up front in order to make sure your dividends received are enough to buy at least one whole share otherwise your dividend will be distributed as cash.
In collaboration with Karen @ Makin The Bacon
Image courtesy of: Sira Anamwong at FreeDigitalPhotos.net