In an earlier explainer, we examined how stock dividends work, and how they can boost growth in an investor’s portfolio over the long term. By reinvesting the relatively small dividend payments some companies regularly make to shareholders, investors can add value to their portfolios.
We heard from a Project Invested reader who wanted more information on dividend reinvesting. So let’s take a closer look at one vehicle readily available to individual investors- the Dividend Reinvestment Plan (DRIP).
DRIPs have grown in popularity over the last couple of decades as more investors seek efficient and low-cost ways to invest.
And for companies, DRIPs are a source of additional capital, through direct investments by existing shareholders.
All told, DRIPs are a real-world example of capital market efficiency in action.
Advantages of DRIP investing
Here’s how it works: many publicly traded companies offer DRIP programs that allow investors to convert their dividends into additional shares of stock. Rather than mailing a quarterly dividend check, the company automatically reinvests the investor’s dividends into additional shares or partial shares of stock commission free and sometimes at a discount to the current share price.
DRIPs also harness the magic of compounding – as you accumulate additional shares through reinvested dividends, those new shares will generate further dividends, which are again reinvested.
So what kind of returns could an investor see through reinvested dividends? Consider a hypothetical example.
Let’s say you invested $1,000 in General Electric in 1985, reinvesting dividends along the way. By today, you’d have a total of $125,522 in your account-a return of 9.84 percent. (Of course results will vary depending on the stock. We used this dividend reinvestment calculator for that example-try it out yourself to see how other scenarios might have played out.)
DRIP investing can be an effective way to invest small amounts regularly over a longer period of time. In this regard, DRIP investing can be particularly appealing to younger investors, who have a longer time horizon over which to invest and receive the benefits of compounding.
While reinvesting dividends can be a solid strategy for achieving gains, there’s no fool proof formula for achieving investment gains, and DRIPs have drawbacks, like every investment strategy.
To begin with, since DRIP investments are in shares from specific companies, those investments are in effect putting all your eggs in that one basket. Investors should take care to develop a broad-based, diversified plan that includes various asset classes, based upon your time horizon and risk preference. DRIPs can be a part of that mix if you’re looking for a lower-cost investing option that will allow you to take advantage of dividend compounding. You should talk to a financial professional before making DRIPs a part of your larger investment plan.
Since you’re buying small amounts of shares and receiving dividends over time, there will be a different cost basis for each block of shares you purchase, which is likely to complicate your tax reporting. Investors will want to be sure to keep careful records of their investments and dividend payments (online access to your DRIP account will help), particularly if your DRIP investment is part of your taxable, nonretirement investments.
Find out if DRIP investing is right for you
And as with all investing approaches, there’s no one-size-fits-all, it’s always a good idea to talk to a financial professional about your savings and investment plans.