When finances are tight and households are making every dollar count, that’s when stock dividends really shine.
Dividends are payments made by publicly traded companies to shareholders who own those companies’ stocks. The payments come in the form of either more shares of stocks or cash payments, and distributions are usually made on a monthly basis.
Investors shouldn’t overlook stock dividends, because the market certainly doesn’t. From 1980 to 2019, 75% of S&P 500 investment returns stemmed directly from dividends, according to GFM Asset Management.
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That’s just one big reason why savvy investors are turning to so-called DRIPs, shorthand for “dividend reinvestment programs.”
What are DRIPs and why do their tight ties with stock dividends offer benefits to investors? Here’s a closer look:
— What are DRIPs?
— Pros and cons of DRIPs.
— A DRIP’s role in an investment portfolio.
— How to invest in DRIP stocks.
What Are DRIPs?
DRIPs are less about specific stocks and more about a program of share reinvestment that can be simpler and cost investors less than if they did it on their own.
“Dividends that are paid out by the company to the equity shareholder are automatically reinvested to buy more shares,” says Stephen Kolano, a financial planner and managing director at Integrated Partners in Wenham, Massachusetts.
Investors are primarily attracted to DRIPs due to a common, yet often overlooked, portfolio strategy that keeps stock shares rolling in on a regular basis.
“In its simplest form, DRIPs are a type of dollar-cost averaging,” says Robert Johnson, professor at the Heider College of Business at Creighton University. “Instead of accepting a cash dividend, the dividend is reinvested at the then-prevailing price.”
For the investor, the most basic advantage relates to long-term planning.
“By reducing costly transaction fees and commissions, the investor is able to put more of his investment dollars to work over the long run and earn more,” Johnson says. “For plans that allow discounted purchases or other perquisites for shareholders, the advantage can be even greater.”
Pros and Cons of DRIPs
Like any investment vehicle, DRIPs have their upsides and their downsides.
Advantages of DRIPs
Allow investors to avoid timing the market. “DRIPs keep investors away from having to time stock purchases, which is very difficult to do,” Kolano says.
Provide tax advantages. DRIPs can be more tax efficient due to tax lots accumulated at lower price points over time.
“That reduces the potential for a large capital gain, which can make selling the stock come with a high capital-gain tax liability,” Kolano notes.
They’re automatic. One of the biggest advantages of DRIPs is that they make reinvesting dividends automatic.
“People should try and automate as many financial decisions as they can,” Johnson says. “One has to make saving money a habit. And habits, good or bad, develop over time.”
A particularly sound way to do this is to agree to have dividends reinvested. “As investors, if we’re automatically enrolled in a DRIP, inertia and the inherent laziness of people tend to work in our favor,” Johnson adds.
Disadvantages of DRIPs
Cash flow issues can be problematic. The main disadvantage of a DRIP program is the reduction in cash flow, in the form of dividends, to the shareholder should they need or prefer to receive cash.
“In order to generate cash flow from a DRIP program, shares have to be sold, which can come with capital gains, as opposed to dividends that are paid regularly,” Kolano says. “Depending on the income tax bracket of the shareholder, dividends may be taxed as ordinary income compared with capital gains.”
Additionally, companies that pay qualified dividends should be taken into consideration given that qualified dividends are taxed at up to a 20% rate, similar to capital gains. “This points out the unique circumstances that an investor should consider in comparing a DRIP stock versus receiving dividends in relation to their own tax situation,” Kolano adds.
Higher stock prices can curb a DRIP’s impact. If a stock trends in an upward direction for a long period, the advantages of a DRIP are less apparent.
“That’s because the underlying cost basis of acquiring shares will continually move higher and lessen the tax efficiency, in comparison to a stock that tends to move up and down more regularly while trending higher at a slower rate so that lower-cost-basis shares can be acquired,” Kolano says.
Lack of cash available. DRIPs may not be suitable for investors who rely on immediate cash flow. In addition to the dividends being reinvested instead of paid out as cash, “investors may have less control over the price at which they purchase additional shares, as the reinvestment is typically executed at the prevailing market price,” says Xavier Epps, CEO at XNE Financial Advising LLC, a financial advisory firm.
A DRIP’s Role in an Investment Portfolio
DRIPs are something of a Swiss army knife, with multiple investment uses.
“They play several important roles (as) dividend reinvestment plans in a broader investment portfolio,” says Matthew Meehan, CEO at Shield Advisory Group. Here’s where they work best:
As a long-term investing strategy. DRIPs promote a long-term, buy-and-hold investing strategy because they are made to automatically reinvest dividends. “With continued use of this method, enormous money can be generated,” Meehan says.
For dollar-cost averaging. DRIPs automatically reinvest dividends throughout the year, “minimizing the danger of making a sizable investment at an inconvenient time and reducing the impact of short-term price swings,” Meehan notes.
For flexibility. To achieve the right balance between income and growth in their portfolio, some investors may use DRIPs in conjunction with other investments.
“To build a diverse portfolio, an investor, for instance, might hold a combination of stocks, bonds and DRIPs,” Meehan says.
How to Invest in DRIP Stocks
Take these tips to the table when looking to add a DRIP:
Consider your tax circumstances and need for cash flow in the near and medium term. “Take a thorough look at how a DRIP program may compare to receiving traditional stock dividends,” Kolano says.
Always consider the underlying company fundamentals. Review the dividend-paying company’s balance sheet quality, free cash flow generation and ability to pay dividends going forward.
Track the company’s share price regularly. If you’re interested in a specific dividend-paying company, look at the trend in the stock price to see if there are ups and downs in how the stock trades.
“Check to see if there’s a clear and strong upward trend that would lessen the ability to acquire lower-cost shares at regular intervals,” Kolano adds.
Diversify. Although setting up a DRIP and forgetting about it is simple, avoid letting this result in an unbalanced portfolio. A diversified portfolio is still preferred even if you reinvest dividends to spread risk.
Consider buying DRIP stocks through your brokerage firm. While you can buy DRIP stocks directly from a publicly traded company that pays dividends, try buying them through your broker or financial advisor. That will help you get the best execution price, and your DRIP will go right into your investment portfolio, for easier organization.
Talk to a professional. While DRIPs can be a valuable component of a portfolio of investments, as with all investment choices, they should be made in light of your financial objectives, risk tolerance and time horizon.
“As always, getting advice from a financial professional can help you decide what part DRIPs should play in your overall investment plan,” Meehan says.
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What Is a DRIP Stock? originally appeared on usnews.com
