What are the pros and cons of a dividend reinvestment plan (DRIP)?
What are the pros and cons of a dividend reinvestment plan (DRIP)?
Dividend income has represented roughly one-third of the total return on the Standard and Poor's 500 since 1926. According to S&P, the portion of total return attributable to dividends has ranged from a high of 53% during the 1940s — in other words, more than half that decade's return resulted from dividends — to a low of 14% during the 1990s, when investors tended to focus on growth. If dividends are reinvested, their impact over time becomes even more dramatic. When you reinvest dividends, you are buying more shares of the dividend-paying stock. The reinvested dividends can then start earning returns and dividends of their own, using the power of compounding.
If a stock's price rises 8% a year, even a 2.5% dividend yield can push its total return into double digits. Dividends can be especially attractive during times of relatively low or mediocre returns; in some cases, dividends could help turn a negative return positive, and also can mitigate the impact of a volatile market by helping to even out a portfolio's return. Another argument has been made for paying attention to dividends as a reliable indicator of a company's financial health. Investors have become more conscious in recent years of the value of dependable data as a basis for investment decisions, and dividend payments aren't easily restated or massaged.
Finally, many dividend-paying stocks represent large, established companies that may have significant resources to weather an economic downturn — which could be helpful if you're relying on those dividends to help pay living expenses.
Differences among dividends
Dividends paid on common stock are by no means guaranteed; a company's board of directors can decide to reduce or eliminate them. The amount of a company's dividend can fluctuate with earnings, which are influenced by economic, market, and political events. However, a steadily growing dividend is generally regarded as a sign of a company's health and stability. For that reason, most corporate boards are reluctant to send negative signals by cutting dividends. That isn't an issue for holders of preferred stocks, which offer a fixed rate of return paid out as dividends. However, there's a tradeoff for that greater certainty; preferred shareholders do not participate in any company growth as fully as common shareholders do. If the company does well and increases its dividend, preferred stockholders still receive the same payments.
The term "preferred" refers to several ways in which preferred stocks have favored status. First, dividends on preferred stock are paid before the common stockholders can be paid a dividend. Most preferred stockholders do not have voting rights in the company, but their claims on the company's assets will be satisfied before those of common stockholders if the company experiences financial difficulties. Also, preferred shares usually pay a higher rate of income than common shares. Because of their fixed dividends, preferred stocks behave somewhat similarly to bonds; for example, their market value can be affected by changing interest rates. And almost all preferred stocks have a provision that allows the company to call in its preferred shares at a set time or at a predetermined future date, much as it might a callable bond.
Look before you leap
Investing in dividend-paying stocks isn't as simple as just picking the highest yield. If you're investing for income, consider whether the company's cash flow can sustain its dividend. Also, some companies choose to use corporate profits to buy back company shares. That may increase the value of existing shares, but it sometimes takes the place of instituting or raising dividends. If you're interested in a dividend-focused investing style, look for terms such as "equity income," "dividend income," or "growth and income." Also, some exchange-traded funds (ETFs) track an index comprised of dividend-paying stocks, or that is based on dividend yield.
Be sure to check the prospectus for information about expenses, fees and potential risks, and consider them carefully before you invest. Also, when investing always take a long-term perspective and dividends and DRIPs are a great way to build a portfolio.
The pros of a DRIP plan are that you will be buying shares on a regular basis and you won't have to make a decision to do so. It is a form of dollar-cost averaging. Sometimes you will buy shares when the stock price has gone down and sometimes not, but over time, your average cost will most likely be lower. It's a good disciplined strategy that over the long-term will pay dividends (pun-intended). I wouldn't hesitate to do this. I don't see a downside except for if you accumulate so much in one stock that your portfolio isn't balanced or diversified. You would want to avoid that.
First, so that there is no misunderstanding, let’s review "What is a DRIP"
DRIPs (Dividend Reinvestment Program) are offered by many companies to give shareholders the option of reinvesting the amount of a declared dividend by purchasing additional shares of that stock. Dividends are normally paid to the shareholders as a check or deposited to their account but with a DRIP the dividend is in the form of additional stock. The term DRIP is not considered the same as automatic reinvestment in a mutual fund.
There are several pros of a DRIP
- No commission on the sale of the stock.
- There can be a discount on the purchase price of 1-10%
- Out on sight and out of mind. You do not spend the dividends and you get compounding growth over time.
- Buying shares on a preset basis- sometimes high and sometimes low.
Contrary to others, I see some possible downsides.
I am a big believer in diversification in your portfolio and that by owning hundreds or thousands of companies (in Mutual funds or ETFs) there is less risk than by owning a handful of stock. Many people who buy individual stocks do not have adequate diversification of their portfolios. So, with DRIPs you are accumulating more shares of the same companies that you own and are not diversifying more.
DRIPs are most common for US large stock companies. You should also have foreign developed, emerging markets and small cap stocks as well as fixed income holdings. If the only investing you are doing is the DRIPs then you will be getting out of balance.
I like using dividends to reinvest in the areas of the portfolio that are under-represented so that your allocation of the entire portfolio is closer to the ideal, as expressed in your investment policy statement.
This is a great question and something that many investors either take for granted or don't consider. In general I always have my dividends reinvesting to buy more shares of the company paying the dividend. There have been a few exceptions when managing investments for our clients and those include the following:
1. Taxable account and the investment is fully appreciated. I have some clients invested in Kohl's (Ticker: KSS). Kohl's has experienced significant price appreciation especially since the announcement about their partnership with Amazon. Some of those investments are in taxable accounts, and considering it was purchased within the last 12 months I don't want to sell the position to realize a taxable gain. In addition, the client is receiving about 6% in dividend income off their original purchase price. Rather than forfeit this nice dividend and pay the taxes I turned off the dividend reinvestment plan so the dividends will accumulate cash to buy a new position.
2. As some folks switch from wealth accumulation to income I have switched the dividend reinvestment plan off to pay income that is distributed to my clients.
3. There have been a few times where I have utilized closed end funds that I felt were in line for price appreciation, but instead of reinvesting the dividends and income I had the income paid to cash where I dollar cost averaged into an S&P 500 Index fund.
Your custodian should not be charging you to reinvest the dividends, and if that's true for you then I would generally suggest reinvesting. Reinvesting allows you to take advantage of dollar cost averaging on new shares. As you know the share price will fluctuate with time, and if the share price drops then these dividends are picking up more shares at a lower price and simply lowering your average cost.
Hopefully that helps, and good luck to you!
Matt Ahrens, CIMA®
This is a great question. It is also something that many investors do not even consider. When I first started investing, I used DRIPs as a low-cost means of building my investments and dollar-cost averaging into my positions. With the signficant drop in commissions that has occurred, the kind of DRIP I am referring to is much less commonplace than it used to be. The original DRIPs were directly with the company. Many firms allowed you to buy a share directly through the company's custodian. Then you could use the dividends to buy more shares. You could also send checks to the custodian to buy more shares on a monthly basis.
Today, most of the major discount brokers allow you to use your dividend proceeds to buy more shares of the company paying the dividend without paying commissions. What happens in this case is essentially this: All of the money that is reinvested in dividends for a particular broker is pooled. Then shares are purchased and those shares are re-allocated to those participating at the average price paid for all such shares purchased.
I generally favor reinvesting dividends when there is no cost to doing so. But, there can be circumstances where it does not make sense, too. Here are what I see as the primary pros and cons:
- Your dividends are used to repurchase shares using a form of a dollar-cost averaging approach. While the amounts may pale in comparison to the investment itself. If you are a long-term investor, they can add up over time.
- As long as you believe the stock is not fully valued, dividend reinvesting provides a means to put your cash back to work without incurring additional cost.
- If you do not need the cash, then reinvesting dividends keeps you from building cash in your account. Also, as you grow your share count, there are two ways for your dividend to grow: Dividend (1) increases by the company paying the dividend; and (2) greater dividends because you own more shares.
- The biggest negative in my mind is that if the shares are held in a taxalbe account you have additional record keeping. Every time you reinvest your dividend, you are purchasing shares. You must track each of these purchases. Otherwise, if you decide to sell the shares, you won't know what you paid for them. Note that brokerages are currently required to maintain such information as well, but I still recommend keeping your own records
- If you are in the stage of life where you need to withdraw money from your accounts, then it makes sense to stop reinvesting dividends. That way you won't have to sell shares to raise cash. You can simply use the dividends to help meet your current cash needs.
- You believe the shaes are fully valued. This means there are likely better places to invest your money, so you should use the cash to buy something besides more shares of a fully valued stock.
I hope this helps. Please feel free to contact me if you have additional questions.