Many people love the efficiency of automation, even when it comes to some forms of investing.
One of the best examples is participation in a dividend reinvestment plan (DRIP) see, in return for filling out a little enrollment paperwork, investors can reap even more benefits from investing in stocks they already love.
What Is A DRIP?
Investors love this for several reasons (as you'll see below), but companies love it too, because they get reliable access to a steady stream of capital. They also tend to attract longer-term investors, which lessens the volatility of the stock to some degree.
There are three types of DRIPs: plans administered by the companies themselves, plans operated by a transfer agent, and those managed by brokerage firms. Here's a brief look at each of these three alternatives:
Company managed DRIPs are administered from a firm's corporate headquarters. They often allow investors to initiate DRIPs without having previously owned shares in the company. Shares that come from a company-operated DRIP generally can't be sold on the secondary market--the company must repurchase them.
Transfer agent operated DRIPs, which involve companies like EquiServe and Chase Mellon, often provide services at a lower cost than company-run programs.
Brokerage firm administered DRIPs generally allow shareholders to reinvest dividends at no cost, even if the company in question does not have a formal DRIP in place. However, these brokerage-run plans do not allow cash purchases and the DRIP plan applies to dividends only.
Making DRIPs Work For You
There are a host of reasons DRIPs can be a good idea.
Cheaper shares. One of the biggest advantages of participating in DRIPs is that you can acquire additional shares of the company at a very low cost -- typically at a discount of one to ten percent of the stock's current market value.
Cheaper transactions. Another big advantage is the low transaction fee for doing this -- often lower than paying a commission to purchase the shares outright. Some DRIP programs even charge no fees at all.
Dollar-cost averaging. Participating in a DRIP means purchasing shares over the course of time, both when the share price is high and when the share price is low. This tunes the investor's return to the overall market trend rather than specific peaks or valleys. It also helps reduce the costs basis on securities that decline in value.
Flexibility. Investors can generally invest as much or as little as they like, making saving and investing much easier.
The Importance Of Compounding
Perhaps the biggest reason DRIPs are a good idea for many investors relates to the awesome power of compounding.
Compounding refers to the process of exponentially increasing the value of an investment by earning interest on both principal and previous interest payments. When investors use their dividends to by more shares, the same effect takes place. Compounding is often described as "magic" because it is one of the most fundamental ways to build wealth, yet it takes the least amount of effort. Given time, earning dividends on dividends can exponentially grow wealth.
For example, suppose an investor buys 1,000 shares of stock in XYZ Corp. at a purchase price of $10 per share (for an initial investment of $10,000). Next, let's assume that XYZ pays a steady annual dividend of 10%, and the shares rise at an +8% annual rate going forward.
The very first quarterly dividend check would be worth just $250: [($10,000 x 0.1)/4]. While that amount will certainly not go very far on its own, it is enough to purchase around 25 more shares at the initial $10 per share price. Of course, those 25 shares would then generate dividend payments of their own.
After 30 years, the initial 1,000 share stake in XYZ would have grown to 17,449 shares! At the same time, assuming a conservative +8% compounded annual growth rate, those shares would have soared from $10 to more than $100. As a result, the beginning $10,000 investment would have swelled to more than $1.7 million dollars, without ever adding another penny!
But what would have happened if the investor just pocketed those dividend payments year after year? Well, the stock would still be worth about $100 after 30 years, but without any reinvestment he or she would only be left with the same 1,000 shares, for a total of approximately $100,000. Even when the cumulative dividends paid of $122,346 are included, the entire investment would still only have grown to around $223,000, which is more than $1.5 million less than with dividends reinvested.
It's also worth pointing out that at the end of the 30-year period, the first portfolio would be generating annual dividend payments in excess of $170,000 ($1.7 M x 0.1). In other words, the investor's annual dividend income alone would amount to more than 17 times his or her initial $10,000 outlay!
The Investing Answer: As you can see, adding a DRIP to your portfolio can be a good idea. But not every company offers a DRIP, and not all DRIPs are the same, so do your homework before investing. Also, remember that even though the dividends are being reinvested, they're still your dividends and you need to pay taxes on them accordingly.