The Pros and Cons of Dividend Reinvestment Plans

investing for dividends vs capital growth

Discover how dividend reinvestment plans can be part of your portfolio—but with a couple of caveats

Some high growth dividend stocks give their shareholders the opportunity to participate in dividend reinvestment plans (DRIPs). These dividend reinvestment plans let investors use their dividends to buy new shares, sometimes at a discount to the market price.

The pros and cons of Dividend Reinvestment Plans

Overall, we think that dividend reinvestment plans are okay to participate in. But we think there are a few important points to keep in mind:

  1. Many investors make their investment choices solely on the basis of the existence of the DRIP option. We think the availability of a DRIP is only a bonus, rather than a reason to invest by itself. Investing only in stocks that offer DRIPs limits both investment choice and opportunity.
  2. The advent of the low-cost discount brokerage and online investing has reduced the commission cost of investment trades. Thus, the commission-free investing that DRIP investing allows is less of an advantage today than it was in the past.
  3. Taxes are still payable on dividends that are reinvested.

Most companies that offer DRIPs provide details on their web sites. Another place to look for information is on the inside back cover of most companies’ annual reports. You can also contact the investor relations department of companies you wish to invest in.

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How to take advantage of Dividend Reinvestment Plans

Dividends and dividend reinvestment plans are in fashion with investors right now, and that’s always a good thing. After all, creative accounting can produce false impressions of prosperity and hide embarrassing financial problems. But accounting can’t create cash for this year’s dividend, let alone conjure up a history of past dividends. Did you know that dividends can produce as much as a third of your total return over long periods? Stick to dividend payers and you’ll avoid most of the market’s greatest disasters.

You should also keep these two important points in mind:

Dividends can grow. Stock prices rise and fall, so capital losses often follow capital gains, at least temporarily. Interest on a bond or GIC holds steady, at best. But companies like to ratchet their dividends upward—hold them steady in a bad year, raise them in a good one. That gives you a hedge against inflation.

For a true measure of stability, focus on companies that have maintained or raised their dividends during recessions and stock market downturns. These firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they provide an attractive mix of safety, income and growth.

How to participate in DRIP investing

To participate in a DRIP, you must first own and register one or more shares of a company’s stock. Share registration (through a traditional or discount broker) will generally cost between $40 and $50 per company. Then you must contact the company to ask for the form you fill out to enroll in the plan.

Overall, we think drip investing is a good way to build wealth over a long period of time. But here are a few things to keep in mind:

A DRIP is not a sign of investment quality: We think DRIP investing is okay to participate in if you use them to cut commission costs on stocks you would have bought anyway. But confining your investments to stocks that offer DRIPs is a terrible idea. That’s because not all stocks that offer DRIPs are good investments. And you can lose a lot more on these stocks than you could ever save on commissions.

DRIP investing has lost some of its cost-saving advantages: DRIPs offer much less of an advantage now than they did in, say, the 1980s, when brokers charged 2% or more to buy stocks. Now, thanks to the growth of discount brokerage and Internet competition, you can buy stocks for a commission cost of 0.5% or less. In addition, many companies that offer DRIPs have done away with the discounts that used to be common. Now you pay full price to buy through most DRIPs.

Careful record keeping is still necessary with DRIPs: You’ll need to keep careful records of all purchases to compute your capital gains and losses when you sell. Many investors find this particularly troublesome, especially when they inherit the task. As well, keep in mind that you must still pay taxes on dividends that you reinvest.

Where to start with Dividend Reinvestment Plans

Don’t know where to start with DRIP investing? You should look first at our dividend stock recommendations. Here are few indicators of dividend quality we look for:

  • High-quality dividend paying stocks should have a history of paying a dividend. One of the best ways of picking a quality dividend stock is to look for companies that have been paying dividends for at least 5 to 10 years. Companies can trump up quarterly earnings, issue press releases to appear to be making strong progress, but they cannot fake dividends. Dividends are cash outlays that an unsuccessful company could never produce. A history of dividend payments is one thing that all the best dividend stocks have in common, and one you’ll want to seek out if you’re interested in DRIP investing.
  • The best dividend stocks dominate their markets. We look for Canadian dividend stocks that have industry prominence, if not dominance. Our reasoning, besides brand recognition, is that major companies can influence legislation, industry trends, etc. to suit themselves. Minor firms can’t do that.
  • Dividend stocks with very high dividend yields should be examined very closely. While they seem enticing for DRIP investing, they are sometimes indicative of a stock that may soon cut its dividend rate.

Follow our three-part Successful Investor strategy

  • Invest mainly in well-established companies;
  • Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
  • Downplay or avoid stocks in the broker/media limelight.

Are you invested in any dividend stocks with DRIPs? Have they been profitable for you? Share your experience with us in the comments.

Comments

  • One aspect of DRIP’s that has not been mentioned is that some company’s do offer the ability to purchase addition shares without fees. When I started investing many years ago I had only a little amount I could direct to building a portfolio. I open a DRIP in TRP and BCE was able to invest 25.00 per month in each company. “How you say?” as the minimum is a lot higher than that. BCE had a minimum of $50.00 so invested that amount every 3 months and $100.00 every 3 months in TRP. I kept the investment going until I had purchased enough so that I had a $5000.00 nest egg in each company. So not only was I reinvesting dividends I was also dollar cost averaging over 6 to 8 years. To me, with out a DRIP, I might not be in the market today.

    Robert

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