Reasons for Investing in DRIP Programs

The past eighteen months have been nothing short of a rollercoaster ride for investors in our security markets. The influences of a European debt crisis, flights of capital to safe havens, lack luster recovery efforts in the advanced economies of the world, and upward spiraling inflation in our commodity markets have been a few of the “lessons” included during this period of uncertainty and volatility.

While economists are predicting more of the same for the next decade, the investor that does not enjoy the “thrill” of a wild amusement park ride has more reasons that ever to consider the wisdom of investing in corporate dividend reinvestment programs, or “DRIP’s” as they are commonly called in the investment community. The process involves registering with a company that offers a “DRIP” and then allowing this wealth accumulation strategy to work to your advantage. There are obvious benefits of not having to pay brokerage fees, dollar-cost averaging, and owning fractional shares, but there are also other larger advantages to consider, as listed below:

1) Total Return: Nearly every beginning investor believe that their increase in wealth will come from wise stock selection and large capital gain realization. The simple fact that has been confirmed time and again by independent studies is that 99% of investor gains, after taking inflation into account, have come from the impact of reinvested stock dividends;

2) Rule of Compounding: Every experienced investor realizes that a program of repetitive saving over time is the path to financial security. Continued investment contributions compound over time, producing what is termed as the “multiplier effect”. All wealth accumulation strategies depend on this simple rule of regular savings over time to reach their investing objectives;

3) Safety and Security: The wise investor knows to focus on “blue chip” companies that are large and that have been around for a long time. These companies produce predictable earning streams that generate dividend yield in the 3% to 5% range, through good and bad business cycles. For this reason alone, stock values will tend to follow tight valuation ranges, and the potential for a major failure is diminished from a risk perspective;

4) Stability: If a rollercoaster ride is not for you, then investing in large, stable dividend-paying companies should be right up your alley. You may not get the dramatic volatility that comes with smaller corporate offerings or other investment vehicles like currency trading, but you will get a more consistent performance range that will allow you to sleep soundly at night;

There are many companies that offer “DRIP” programs, but focus on large companies on the Dow Jones Industrial Average or the S&P 500 Index. Stay with “blue chips” and avoid the pitfalls of smaller companies.

What is a DRIPs? (Dividend Reinvestment Plan)

Dividend reinvestment plans (better known as DRIPs) sound complex in nature, but are fairly simple in definition. When a dividend is paid by a company, you have 2 options:

#1 You receive your dividend payout in cash in your investment account

#2 The dividend payout is automatically reinvested in the same investment issuing the dividend

Essentially what happens is that instead of receiving your dividend payment via cash, you instead have the option to use this payment towards purchasing more stock in the company.

By agreeing to a dividend reinvestment plan the investor is increasing their stock holdings. The investor’s cash account will not increase but they will own more and more shares every quarter. This is an ideal option for the investor with a long term mind set. The amount of shares purchase as part of a DRIP plan depends on how much money you’re owed as a dividend payment as a result of your stock holdings.

What is the benefit of a dividend reinvestment plan?

The benefit is that the investor has the option to purchase more shares in the company without going through their brokerage. The investor automatically reinvests their money because they purchase more stock in the company. Therefore, you put your investing on auto-pilot and you grant the company permission to use your cash payment to buy more shares at the given price. You also get to avoid brokerage fees in most cases.

The other benefit is that you don’t have your dividend payments sitting around in a cash account. You also don’t have this money available to spend foolishly. Instead the money is used to reinvest in the company that you originally started investing in.

Finally, some companies offer a bonus to investors who subscribe to their DRIPs. They can offer the investor to reinvest their dividend through buying shares with a 5% rebate on the stock market value for example. So if the stock is trading at $100, you will be able to reinvest your dividend by buying shares at $95.

A word of warning on DRIPs

New investors must watch out for a common mistake that occurs here. When you use your dividend payment to purchase more stocks in the company this is NOT FREE MONEY. You’ll be taxed on this. So we ask you to please consult your tax adviser if you have any further questions on DRIPs and taxation.

There is also a possibility that your brokerage account doesn’t offer DRIPs. This is important to consider this factor before choosing your brokerage firm and open a trading account.