Perhaps the biggest advantage of investing in dividend-paying stocks is that reinvesting your dividends can increase your returns considerably in the long run. This strategy is commonly referred to as a dividend reinvestment plan (DRIP).
Under a dividend reinvestment plan the dividends paid by the stocks you own do not reach your brokerage account at all. Instead, the cash is directly reinvested to buy more shares of the company which paid you the dividend.
There are many reasons why a reinvestment program makes perfect sense, but this strategy is especially powerful if you are young and looking to build long-term wealth.
Let’s look at some of the immediate advantages of this passive investment strategy.
You are not required to pay investment fees for the shares you buy through a DRIP. In the absence of a DRIP, you might have to pay a fee to your brokerage firm for the shares you buy using dividend payments, especially if you take the dividend as cash and then choose to reinvest at a specific time. (You might do this if you are trying to time your purchases to get a lower price for the stock or you want to buy a different stock instead.)
Many brokerages now reinvest the dividends of a given stock or fund back into that stock or fund at no charge, but read the fine print carefully.
Let us say a company pays you a quarterly dividend equal to $100. If you have opted for a DRIP the entire amount can be reinvested by the company to buy more shares of the same company.
If not, you pay either a flat fee or a small percentage of the transaction to the brokerage firm. If your brokerage firm charges a $7 fee, you are left only with $93 to buy the shares.
A $7 fee might not mean much to you in the short term, but it can make a notable difference to your returns in the long term. If you pay a $7 fee for buying shares using the dividend payments every quarter, you pay $28 a year.
Assuming you own the stock for 20 years, you would pay $560 in transaction charges alone. If instead that extra money is invested it compounds into more than $1,200 extra in your investment portfolio at a typical market rate of return.
The total difference is $1,760. Wouldn’t you rather have that money?
A DRIP also allows you to buy fractional shares of high-priced blue-chip stocks, lots of which are normally unavailable to the ordinary investor on the open market.
Let’s say you own 50 shares of Coca Cola (KO). The company currently pays a quarterly dividend of 40 cents a share, which means you will be paid $20 every quarter.
This amount is not sufficient to buy a single share of Coca Cola, which (at the time of writing) trades at $48. With a DRIP in place you can buy approximately 0.4 shares of Coca Cola. These fractional shares add up over time and can help you get better returns in the long run.
Dollar cost averaging
A DRIP can help you become a disciplined investor and take advantage of the dollar cost averaging process, which involves investing a set sum of money in stocks on a regular basis. A DRIP automatically invests your dividend payments back into the stocks you own.
When the prices are low that money buys more shares. When they are high you buy a smaller number of shares or perhaps a fractional share.
Compared to trying to time your purchases (and often getting it exactly backward it seems), dollar cost averaging helps you get more shares at the best prices over time and that often translates into higher returns in the long run.
A DRIP gives you the choice to enroll all or some of the stocks you own in a reinvestment plan.
For instance, if you own six dividend-paying stocks you can choose to enroll all of them in a DRIP. Alternatively, you can enroll four of them in a DRIP and opt to receive the dividend payments as cash income from the other two stocks.