Dividend Reinvestment Plans
A Dividend Reinvestment Plan, more commonly known as a DRIP is an automated reinvestment strategy.
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.
Set it and Forget It
A DRIP requires minimal maintenance, so it can truly be a “set it and forget it” investment. Because a DRIP enables you to automatically invest, you will be less likely to react to your emotions. This can have a significant affect your bottom line. When you use a DRIP, you are less likely to sell in a down market, which will keep you from taking a potential loss on your shares.
Eliminates Buying Hesitation
Not only are you less likely to sell, but you eliminate the hesitation to buy that may occur when prices decline. By continuing to buy shares when prices are down, you reduce the average cost of your shares, which offers you the potential for greater long-term profitability. Moreover, your dividend payment buys even more shares when prices decline.
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Efficient Investing
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.
Staying Diversified
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.
DRIP Taxes
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.
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