One of the first investment concepts to grasp is that compound interest and earnings can help an investor’s portfolio grow.
If an investor buys an asset which pays out interest or dividends, and then they reinvest those earnings into buying more of the asset, they are then earning on both their initial investment and on the interest. This is compounding.
There are many types of investment options, and some of them are especially good for investors looking to compound earnings over time.
One way to earn on an investment and then reinvest those earnings for compounding returns is through Dividend Reinvestment Plans, or DRIPs.
Shareholders can enroll in DRIP programs to make their money continue working for them, rather than just receiving a dividend payout. This can be done directly through an investor’s brokerage firm, if they have one — but there may be a fee.
Adding small amounts of money to a portfolio over time may add up to a major increase in the long run. Some investors favor DRIPS because of their low fees, ease and potential to increase returns over time.
What are dividends?
Before diving into DRIPs, it’s helpful to have an understanding of dividends themselves. Dividends are payments made by corporations to their shareholders. These payments are distributions of corporate profits.
When a company earns a profit, they can reinvest that money into the business as well as payout a percentage to shareholders. Dividend payments may be made quarterly or annually, and are either provided as cash or as stock.
Not all companies pay dividends, partly because companies don’t all make enough money to cover their expenses and pay shareholders. Most of the companies that pay dividends are large and have been in business for many years.
Rather than receiving a dividend check in the mail or cash into your brokerage account at the end of each fiscal quarter, investors can choose to reinvest that money through a DRIP.
What is a dividend reinvestment plan – DRIP?
DRIP programs give investors the opportunity to reinvest cash dividends from stocks they own into additional shares or fractional shares of those stocks.
This reinvestment takes place on the dividend payment date. Shareholders can join formal Dividend Reinvestment Plans offered by the companies they’re invested in. About 650 companies currently offer DRIP shares.
How do dividend reinvestment plans work?
When an investor buys shares in a company that pays dividends, those dividends normally get paid out as a direct deposit or check. If investors sign up for a DRIP program, they have the option to reinvest the dividends rather than receiving the payout.
The reinvested dividends go towards additional shares of the same stock and are generally purchased directly from the company. Brokerage accounts can also offer DRIP shares to shareholders — usually for free or a small fee.
Usually, DRIP shares are issued directly from the company’s reserves. The shares can’t be bought or sold on stock exchanges, they must be traded directly with the company or broker.
Types of DRIPs:
Corporations offer their own dividend reinvestment plans. Some companies hire outside firms or transfer agents to run their DRIP. Although company DRIPs used to be common, fewer than 1,000 companies on the U.S. Stock Exchange currently offer them.
Online brokerages such as TD Ameritrade and Merrill Edge offer DRIPs. These can be easier for investors looking to invest in multiple stocks, and they have a large offering of companies. Shareholders can choose to enroll in DRIPs for all of their investments or just for select companies.
Dividend Reinvestment Programs are a perk for existing shareholders. Often, investors are able to buy the DRIP shares with zero commission or just a small fee, and at a discount from the current share price.
Investors must still report the dividends as taxable income even though they don’t receive them. You’ll want to consult a tax expert.
Pros and cons for investors
There are a number of reasons investors choose to reinvest their dividends through a Dividend Reinvestment Plan, and several reasons companies choose to offer them.
Since companies offer the shares at a discounted rate and typically no commission, investors save money and are able to buy more shares.
Discounts on DRIP shares can be anywhere from 1% to 10%. Investors can also purchase fractional shares through DRIPS. This is useful because dividends payments may not be enough to buy an entire share of the stock.
The biggest advantage of DRIPs for investors is the compounding of returns. Investors can set up automatic reinvestment of their dividends into DRIP shares so they don’t even have to think about it after the initial set up.
Through the DRIP program, investors are earning on any stock price increases, the dividend payouts which get reinvested and the dividends paid out by those new shares. Over time, some companies also increase the amounts of dividend payouts.
Also, even if the price of the stock goes down, that means the reinvested dividends can be used to buy more shares. The total potential return of the investment continues to go up.
Pros for investors include:
• Possibly purchase shares at a discounted rate
• Pay low or no commission
• Purchase fractional shares
• Earn compounding returns
• Automated Purchase
Although there are a lot of upsides to the DRIP method, there are also a few downsides. DRIP shares aren’t as liquid as normal shares and can often only be sold back to the company directly. This means it will be difficult for an investor to quickly sell off shares.
If an investor sets up automated DRIP investing, it can be easy to forget about the investment and not monitor it closely. Although the DRIP investment may be attractive at first, over time the market can change and the investor may want to allocate their money elsewhere, rebalance, or further diversify their portfolio.
Knowing which stocks to buy and when to buy and sell them is challenging for everyone, but DRIP investing can add in some extra challenges.
Investors sometimes use dividend income to invest in new stocks, but with DRIP investments they must invest the money back into more of the same stock. This further prevents portfolio diversification.
Finally, figuring out tax reporting can be complicated with DRIPs. Investing in an IRA or using a brokerage account can help keep track of DRIP transactions. Again, consult a tax professional.
Cons for investors include:
• Shares can be less liquid than those on an exchange
• It’s important to keep an eye on investments
• Can prevent portfolio diversification
• Tax reporting can be complex
Advantages for companies
Companies choose to offer DRIP shares for a few reasons. The money shareholders reinvest into the company is capital investment that they can use to keep the company running and growing.
Also, DRIP shares are less liquid than regular shares since they can’t be sold on a public exchange. This means investors are more likely to hold onto the shares.
Shareholders in DRIP programs tend to be long-term stockholders anyway, since they are using the DRIP program to grow their portfolio and have chosen to enroll in the plan with that particular company.
Pros for companies include:
• More capital for the company to use
• DRIP shareholders are more likely to hold their shares for the long term
Real-world DRIP examples
Hundreds of publicly traded companies offer DRIP shares. For companies to create a DRIP program they must already offer dividend payouts. Some of the companies that offer DRIPs are:
• Exxon Mobil (XOM)
• PepsiCo Inc (PEP)
• 3M (MMM)
• Coca Cola (KO)
• Sherwin Williams (SHW)
Here is one example of a DRIP in action:
The DRIP offered by Exxon Mobil (XOM) offers shareholders dividends of $1.76 per share each year, (or $0.44 each quarter). Shareholders who take advantage of the DRIP reinvest that money into more Exxon shares.
If a shareholder owns 100 shares of Exxon Mobil, they receive $44 in dividends every quarter. If Exxon’s stock price is $88, the dividend reinvestment will buy the investor half of one share of stock. They then earn interest on that share of stock as well as the shares they already own.
Getting started with DRIP investing
In order to start earning with the DRIP method, investors must first own shares of stock in companies that offer dividend reinvestment. The share or shares must be owned in the investor’s name, not a broker’s name.
Since there are hundreds of companies to choose from, it can be challenging to figure out which DRIP is the best. Some of the most popular and effective DRIPS are offered by Dividend Aristocrats. These are companies that have increased their dividend payouts every year for at least 25 years.
Dividend Aristocrat DRIPS help investors earn even more on their investment since they have more dividends to reinvest each year.
A number of these companies also charge zero fees for the purchase of DRIP shares, making them even more attractive to investors. This type of DRIP is a powerful and cost-effective compounding investment.
Examples of Zero Fee Dividend Aristocrats with DRIPs:
• Aflac (AFL)
• AbbVie (ABB)
• A.O. Smith (AOS)
• Emerson Electric (EMR)
• Federal Realty Investment Trust (FRT)
• Hormel Foods Corp (HRL)
• Ecolab (ECL)
• Exxon Mobil (XOM)
• Illinois Tool Works (ITW)
There are also non Aristocrat companies that offer zero-fee DRIPS.
Building a portfolio to reach your goals
Whether you’re already invested in the stock market or are looking to get started, there are useful tools available to help you keep track of your favorite stocks and your portfolio.
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