What is a DRIP?
Instead of receiving your dividend payment in cash, it is automatically reinvested back into shares. In other words, DRIPS allow you to consistently drip money back into your investment.
A DRIP also allows you to purchase whole or fractional shares, making them a particularly efficient way to reinvest. But of course, the biggest benefit of a DRIP is compounding growth. By putting your money back to work quickly and consistently with more shares after each payment your next dividend is automatically larger assuming the per share amount doesn’t change.
However, DRIPS can lead to diversification drift. Ideally, you would create and maintain a balanced portfolio. But when you invest in DRIP, over time, you will likely increase your holding in a stock that has a declining price and decrease your holding in a stock that has a higher price.
You will also automatically reinvest the most money in your highest-paying dividend stock. As this continues, this holding can become significantly overweight when compared to other holdings in your portfolio. Keeping your portfolio well-balanced and properly diversified is critical to risk management.
One last important note, unless they are held in a tax-qualified account, even though the dividends you receive through a DRIP are automatically reinvested, they must be reported and are still taxable.