Dividend Reinvestment Plan Explained

It’s time for another review. Most brokers will offer a Dividend Reinvestment Plan (DRIP) for stocks, mutual funds, and ETFs that regularly distribute dividends. Investors also have the option to opt out of this feature and invest the funds elsewhere. Is it more advantageous for investors to reinvest the dividends or to move on with another investment? We will take a look at this more in-depth below.

What Is a Dividend Reinvestment Plan?

First, what are dividends? Some public companies or funds will reward their investors with cash distributions.

Oftentimes, every quarter. Most companies that pay dividends are value stocks or have been established in the market for a long time.

A growth stock will very rarely pay its shareholders. These will decide to reinvest their profits back into the business. Some funds invest in certain sectors that distribute dividends as well. Below are a few examples.

Which Companies or Funds Pay Dividends?

Dividend Reinvestment Plan

The energy sector includes oil, gas, materials, metals, chemicals, and other products. Companies in this sector often pay a higher than average dividend yield than their competitors.

However, the price of commodities tends to fluctuate. ExxonMobil’s (NYSE: XOM) dividend yield is 4.09%. Brookfield Renewable Partners (NYSE: BEP) offers a 3.31% dividend yield. 

Consumer goods products can also be regular dividend payers. Everyone will always need these products no matter the state of the economy. They pay less than other sectors but the stocks are more stable over time.

Tobacco companies are the ones who pay the most. Philip Morris (NYSE: PM) and Altria (NYSE: MO) respectively pay 5.30% and 6.77%. Meanwhile, Coca-Cola (NYSE: KO) and Walmart (NYSE: WMT) respectively pay 2.85% and 1.57%. 

Finance, healthcare, and other industries also pay attractive dividends. ETFs also offer a dividend reinvestment plan and are better for diversification purposes. For more information on dividend-paying stocks, please visit this article

Understanding a Dividend Reinvestment Plan

What is a dividend reinvestment plan in simple terms? When the company distributes its dividends, a will allow investors to reinvest the funds into full or partial shares automatically. Some brokers may charge for the service, but most won’t.

It can be set up when purchasing the stock for the first time or by contacting your broker and adding the option to your existing holding. DRIPs are also subject to taxes just like regular dividends. Stay up to date with your current tax laws and your income bracket as percentages may change individually. 

Pros for Investors

Dividends are guaranteed capital for long-term investors. As long as the price of the shares keeps increasing, investors will be happy. Some companies also offer discounts on shares purchased through a DRIP for existing investors. These discounts can go up to 10%. 

Ex: Fortis (NYSE: FTS) is an electric utility holding company that offers a 2% dividend reinvestment plan discount.

The newly purchased shares will be discounted compared to the open market price. Over time, investors can also take advantage of price fluctuations in the market and the returns will be compounded.

It’s also less of a headache for those seeking an automatic approach for their investments. Finally, investors can own fractional shares. This maximizes the return for every dollar. 

Pros for Companies

Companies can also take advantage of their DRIP program. First, they receive more capital for their use. Next, shareholders are less likely to sell their stocks since they are in it for the long-run. A relationship is built between both parties that could last a long time. 

Dividend Reinvestment Plan Growth Example

Dividend Reinvestment Plan

The dividend reinvestment plan example below is purely hypothetical and doesn’t reflect any real-life stocks. It is only for the sake of an example.

Stock A is currently trading at $100 with a 1% dividend yield, so $1 per stock per year. The stock and the dividend price grow by 10% yearly.

You initially buy 100 shares for a total of $10,000. At the end of the first year, you receive $100 worth of dividends and the shares are worth $11,000, for a total of $11,100.  

At the end of the second year, you receive $111 of dividends and the shares are worth  $12,210, for a total of $12,321. If the investor decided to pocket the dividends instead of reinvesting them, his investment and net worth would both be worth less. This goes on until you decide the investment is no longer relevant. When could that be?

When To Stop a Dividend Reinvestment Plan

Investors aren’t obligated to reinvest their dividends. They can simply put the money in other stocks or into their personal accounts. However, those taking advantage of the dividend reinvestment plan may need to stop the investment one day. There can be many reasons for this decision. 

The Asset is Performing Poorly

Sometimes it’s time to move on from a poor investment. While the dividends may be good, the underlying stock may not. If the stock price keeps dropping and there doesn’t seem to be much hope for a recovery, it may be time to pack the bags and look elsewhere. 

Diversification

If an investor owns too many closely correlated stocks, they may seek out stocks in a different sector. Some investors own a variety of stocks in the energy sector. As we are very slowly moving toward renewable energies, some stocks may appear less attractive in the long term. Diversification will allow to spread the risk and invest in new industries.

Rebalancing the Portfolio

Dividend Reinvestment Plan

Over time, it is possible to become overweight in a certain type of security due to DRIPs. We may want to keep only 60% of our portfolio in stocks.

Due to constant reinvesting, that number can increase. The idea then is to sell a portion of the portfolio to rebalance according to plan. The rebalancing isn’t caused by poor performance, but to keep our strategy in line.

Retirement

Retire

That dreaded or exciting period of our life. Everyone’s goals for retirement are different. Some may want to stay near their home and relax.

Others may want to travel and try new things. Depending on YOUR goals, your investment approach will be different.

The first group may want to increase the percentage of their stocks that pay dividends. The second might sell all their stocks and opt for very safe investments to maximize their funds for today. Both strategies are good, but they depend on YOUR goals.

DRIPs Final Take

I hope this little review on reinvested dividends helped. A dividend reinvestment plan program is offered for stocks, mutual funds, and ETFs. It’s a quick and efficient way to reinvest the gains into our favorite investments. Keep in mind that different brokers have different rules for this program and some may charge fees.

If you want to learn more about how you can profit from the stock market, head on over to our free library of educational courses. We have something for everyone, including trading options for those with small accounts.

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