Q: What's dividend reinvestment?
A: It's an option available to people invested in companies with stock that yields dividends, which are a portion of a company’s profits that are regularly passed along to investors.
So, what is it exactly?
Think of a dividend reinvestment program (which goes by the unappealing acronym DRIP) as a savings account with compound interest. Only instead of dollars, you’re accumulating stock. Here’s how it works: Certain companies issue stock that stipulates its dividends—which are a kind of payment that goes to shareholders — will be paid, instead of cash, in the form of more stock. DRIPs can be administered by either the company or the brokerage you use to trade stocks and bonds.
A company DRIP (or full DRIP) that issues a $200 dividend for example, would give the shareholder $200 worth of additional stock. If the share price is $15, the investor would get 13.33 shares. Some companies require you to own only a single share to take part in a DRIP, while others require a higher minimum number of shares.
Brokerage DRIPs, while easier to set up, aren’t true dividend reinvestments because the brokerage cannot issue a fraction of the stock. Using the same example, the brokerage would take your $200 dividend and, at the $15 stock price, buy you 13 shares. The rest ($5) would be issued in cash.
Investors like DRIPs because they’re an easier and cheaper way of buying stock—and you’re not tempted to spend your dividend on sneakers and tasting menus. Companies, on the other hand, like having DRIPs because they can disperse dividends without having to actually use their cash.
What are the pros? The biggest bonus for retail investors is that DRIPs make it cost less to buy a share of stock. Not only does an investor avoid brokerage fees, but companies sometimes offer shares at a discount for investors who are enrolled in DRIPs because companies often want to hold on to their cash.
Another advantage is that when you reinvest, you’re buying stock at lots of different price points. That means you’re utilizing the investment-maximizing principle of dollar-cost averaging. By consistently buying shares every few months, you’re reducing the likelihood of buying all your stock at a peak price.
Anything to be careful about? DRIPs aren’t all sunshine and roses, though (we estimate they are 75 percent sunshine and roses). The most tedious part of DRIPs is that to register for company DRIPs, you’ll need to get an actual, old-school stock certificate from the company to apply. The company will charge you for this certificate, and you’ll need to make sure to keep it safe because it’s proof that you own the shares.
And when you sell the stock, you’re going to have to do some math to figure out how much tax is due—instead of a lot of stock bought at a single price, you’ll be selling stock that you bought at lots of different prices, and each price point will mean a different amount of capital gains. It might be time to hire an accountant.