As you may know, dividends are a powerful way to build wealth without physically having to “do” anything. This is part of what makes portfolio income one of the truest forms of passive income. All you have to do to earn funds is to own the securities that pay out.
When you receive dividend payouts from the companies or funds in your portfolio, you have one of two options:
- Withdraw or hold your money
- Reinvest your money
Withdrawing your portfolio income may make sense if you already have a large base of investable assets that supplement your other streams of income. However, most people do not have the ability to do this until later in their lives. This is where dividend reinvestment comes into play.
Dividend reinvestment refers to the act of using funds paid out by your positions to buy more of the same positions in your portfolio. this can be a great way to automate the asset accumulation process.
Certain companies offer programs that allow investors to automate the reinvestment process, called dividend reinvestment programs. This article will cover what dividend reinvesting is, how it works, and some important factors to consider when making your first moves.
Before we continue, Financial Professional wants to remind you that this article is educational in nature. Any securities or firms named are for illustrative purposes only and do not constitute financial advice. Always do your due diligence and consider your situation – and the help of a licensed financial professional – when making investment decisions.
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What is a DRIP?
Dividend Reinvestment Programs (DRIPs) are common solutions for investors who want to reinvest their returns in companies. This allows them to accumulate more shares over a long period of time without breaking the bank.
DRIPs are set up by the company that issues the stock in which you are looking to invest. These firms often utilize transfer agents such as Computershare to administer the program. The shares that investors usually purchase through these systems typically come from the firm’s Treasury shares, which means that they are not part of the “public float.”
When you originally set up a DRIP, you purchase an initial amount of shares. Once those shares pay out a dividend, the funds are used to purchase more shares in the company’s stock. Furthermore, many DRIPs allow you to purchase fractional shares. Consequently, under these programs you don’t have to build up the capital required to buy a whole share.
As a result, you will experience a snowball effect over time in which you automatically amass more equity in any given firm – without ever thinking about it.
What Are the Benefits of Dividend Reinvestment Programs?
The primary benefit of dividend reinvestment programs is the ability to automatically build your position in a company you are bullish on in the long-term.
The mechanics behind a DRIP involve dollar-cost averaging. The premise behind this calculation is that you will constantly acquire shares on a fixed interval. Therefore, you will reduce the risk of purchasing shares at a bad time. It’s important to remember that market timing is difficult and even dangerous to your bottom line. While the purchase price of the shares you drip will fluctuate over time, the chances of you securing a more favorable average price is greater over long stretches than if you try to pick a random trading day.
Another benefit of DRIPs is that they are typically low cost. This stems from the fact that you are acquiring Treasury shares, or shares owned by the company (not traded on exchanges). As a result, there are no commissions and few to no brokerage fees involved with transactions. This is a major incentive for investors who are fee-sensitive.
Keep in mind, however, that not all DRIPs are created equal. If you have questions about the DRIP in which you are looking to participate, it’s best to do some research to make sure you understand the logistics – especially who the transfer agent or custodian is. Furthermore, consider that the issuing firm also receives a benefit from the DRIP. The proceeds received and reinvested by investors are frequently used to fund the operation.
How Do I Set Up A DRIP?
If you are interested in participating in a company’s DRIP, first research the firm’s Investor Relations. This is where you are most likely to find an application to complete. From there, the process is pretty straightforward and not very time consuming. This is the “true DRIP.” For further questions, you’ll have to contact the Investor Relations department of the firm.
Keep in mind that you can also reinvest dividends in your brokerage account or IRA. However, not all financial institutions offer fractional share ownership. Furthermore, you must be mindful of any commissions and brokerage fees that come with the platform.
Important DRIP Considerations
While dividend reinvestment programs offer several benefits to investors, there are some notable considerations to keep in mind. We will discuss three of the biggest concerns here.
Firstly, look at your concentration risk. This is the term for having too much of any one security in your investment portfolio. Most industry professionals consider a position to be concentrated after it comprises over 10% of your investable net worth. While concentration can provide handsome returns on your portfolio, too much can be detrimental if the company moves into a bear market. For this reason, limiting the effects of maximum portfolio drawdown is crucial to the long-term success of your financial plan. Because you will be accumulating equity in the firm, you should do some research on the firm’s long-term prospects.
Secondly, you need to consider how easy or difficult it will be to work with the share custodian. Most firms outsource the administration of their DRIP to outside organizations, some of which are more tech-friendly than others. If a custodian does not offer a lot of online support, then you may find yourself on hold for hours while they track down a basic tax document.
Thirdly – and speaking of taxes – make sure that you keep track of all dividends kicked off by the shares you own. Even if you reinvest the funds, you still owe income tax on the earnings because they are earned in a taxable account.
Make Dividend Reinvestment Programs Work for You
It’s no secret that dividend reinvestment is one of the most powerful ways to accumulate the most investable assets in your portfolio – or that accumulating assets is the most important element to creating wealth.
The larger the asset base, the more the dividend reinvestment process will snowball. Dividend reinvestment programs can be a fantastic way to participate in the long-term growth of a company you believe in. Once you are enrolled in the process, you will generate wealth and build your portfolio without lifting a finger. (Though do keep in mind that you can continue to fund the account out of pocket if you want to speed up your asset accumulation further).
Furthermore, even if you don’t set up a traditional DRIP, you can still automate the reinvestment of dividends within your brokerage account or IRA.
Questions or comments about DRIPs? Let us know below!