What are the pros and cons of a dividend reinvestment plan (DRIP)?

What are the pros and cons of a dividend reinvestment plan (DRIP)?

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2 weeks ago

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. 

 

 

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