One of the most common strategies to build long-term wealth is to use the dividend reinvestment plan, also known as "DRIP."
A dividend reinvestment is when an investor chooses to purchase additional shares of the same stock that paid them the original cash dividend.
Most investors can use this method considering most brokerages have automatic reinvestment plans available to their customers. If they do not offer this, an investor can simply manually reinvest the dividends themselves.
What is a Dividend?
Still, confused as to what a dividend is? No problem, let me simplify it for you.
Dividends are authorized payments that are paid out to the shareholders from the company’s earnings.
Essentially, if you hold a company’s stock, they will pay you a certain percentage either quarterly or annually. This is a company's "Thank You" for investing in them by giving you a cash reward.
If you are still confused watch this video.
How does Dividend Reinvestment work?
This process is actually pretty simple.
Dividends are typically issued as cash. When people take the dividend in cash, it will be deposited into their account and can ultimately be sent out as a check. Some people choose to build their portfolios around these stocks so they can have a nice cash flow to rely on.
With that being said, some companies offer investors the ability to have their payouts automatically reinvested without any hassle using their DRIP plan.
Instead of receiving a cash payout, an investor will receive additional shares of the company based on the current price of the market. If the dividend payment is less than the cost of the stock prices, the company will instead buy fractional shares of the company.
When do they get reinvested?
Dividends can be reinvested on the first trading day after the dividend is deposited into the investors account.
For example, if it was deposited on a Tuesday, and Wednesday was a trading day, then Wednesday is the first day it could be reinvested.
If it was deposited on a Friday, the first day it could be reinvested would be Monday since Saturday isn't a trading day.
Not every brokerage offers a DRIP program, so make sure you do your research on which brokerage will help you with your goals.
Advantages of Dividend Reinvestment
Investors typically decide to choose this plan because they believe the company they are investing in will continue to grow in the long term, therefore making the stock price rise and be more valuable.
There are also typically no transaction fees involved when using the DRIP method which makes it more appealing to consumers.
Faster Compounding Interest
When investors choose Drip, they choose to put their money back to work and take advantage of Dollar Cost Averaging.
Along with this, the DRIP method also allows investors to purchase fractional shares of the company. This is unique to DRIP portfolios which sometimes aren't available in traditional circumstances.
Instead of sitting in cash in a brokerage account, your money can be constantly and consistently reinvested. This will add to the compound interest boost that so many investors are setting their sights on.
Available to Most Investors
It doesn't matter how much stock you own, if a company offers a DRIP plan then all you need is one stock to start your journey. No matter the quantity, you can start investing immediately.
No minimum amount is necessary.
In addition to this, some companies also offer a discount on their stock prices if you enroll in their DRIP plan.
Disadvantages of Dividend Reinvestment
Lack of Diversity and Opportunity Cost
I'm sure you heard the saying, "Don't put all your eggs into one basket." Most financial experts recommend having a diverse portfolio involving multiple sectors in the market.
Well if you opt into the DRIP program then your portfolio is certainly going to lack diversification.
Along with this, your funds are allocated at certain times, so you may miss an opportunity to get a stock at a discounted price.
Pay Taxes on Dividend Reinvestment
Obtaining dividend income is a taxable event in the eyes of the IRS. So these dividends are taxed like any other payment, so make sure you have enough cash to pay your taxes when tax season comes around.
Make sure you keep a close eye on all dividend reinvestments as well so you don't have confusing tax records.
Not For Short Term Monetization
If you are opting into one of these plans then you are thinking for the long term. Most of these accounts are hard to get in and out of and some companies put restrictions on when you can touch your money.
If you want to trade stocks, make more risky plays, and have easy access to your funds than this plan isn't the one for you.
Should you use DRIP?
The dividend reinvestment plan is a solid way for investors to get more shares of a company they believe in.
Investors typically decide to choose this plan because they believe the company they are investing in will continue to grow in the long term, therefore making the stock price rise and be more valuable.
If you're looking to maximize your gains and take full advantage of compound interest, then this may be the plan for you.
