Stocks 101: What is a Dividend Reinvestment Plan or DRIP?

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As part of a balanced retirement strategy, stocks can be great source of passive income. Buying shares in corporations can be extremely satisfying. Not only do stocks have the potential to increase significantly in value as the products, brands, and intellectual property of a company grows, but sometimes that also means a nice quarterly payout in the form of a dividend.

A dividend is a payment from the company whose shares of stock you own, as a sort of bonus to investors. Companies that pay dividends to their stockholders are known as income stocks, because the stock creates income for the investor. If you are buying stocks as part of a retirement strategy, as I do, you will want to reinvest these dividend payments into more shares of stock.

For small-time investors buying stocks can be an expensive proposition. For the average family budget, retirement savings are important, but they must be squeezed like blood from a turnip, as the old saying goes. And the costs of trading (aka buying and selling stocks) can chip away at your blue-chips' earnings.

Costs of Trading

For the sake of example, let's say you are putting aside $100 a month to invest in the stock market. I use a tax-advantaged Individual Retirement Account (IRA) to hold my stocks. When someone buys or sells a stock, usually through an IRA at an investment broker like TD Ameritrade, IShares, or Charles Schwab, they pay a fee to the broker for placing the trade, usually about $10 a trade at a self-service broker, sometimes a little-less if you are using a no-frills service like Sharebuilder. Think about it. That's $10 in and $10 out. The fees for placing a trade with a broker can quickly eat up a small-investor's profits. 

For example, if I am saving $100 a month and place a trade an average of 4 times a year, and assuming I am not selling the stocks I buy, my stock purchases can ring up $40 or more in transaction costs. When investing relatively small sums ($2-500), this trading fee becomes a huge percentage of the transaction. Before you actually make any money on your stocks, you'll have to make up for that trading fee.

Money doesn't grow on trees, but it can grow in a Dividend Reinvestment Program.  Meg380 Dreamstime.com
Money doesn't grow on trees, but it can grow in a Dividend Reinvestment Program. Meg380 Dreamstime.com

How Dividend Reinvestment Plans Work

But there is a better way. Individual companies have set up a system of automatically buying stocks, using the quarterly dividend payments you earn from your existing stocks. This system is called a Dividend Reinvestment Program.

If you keep your investments at a self-service brokerage account, the purchase of shares is automated by an arrangement between the brokerage and the company paying you the dividends, so you don't actually place a trade. Therefore you don't have to pay the brokerage commission or trading fee to buy more shares of the stock you already own. Even if you don't have a large quantity of a particular stock, when you receive a dividend payment, the DRIP system of buying stock will buy partial shares of stock.

Pitney Bowes (PBI) Real Life Example

Now let's look at an example of using a the performance of a real life stock during 2009 to see how this works:

Adam has a small stock portfolio, and is buying shares of Pitney Bowes (PBI). So far, he has 100 shares of this seller of mail processing equipment. During the first quarter of 2009 (Q1), Pitney Bowes pays him a 36 cent dividend per share. On the dividend payment date, Pitney Bowes deposits $36 into his investment account. A few days later, the price of Pitney Bowes stocks is $19.29 a share. Through his dividend reinvestment plan, his stock broker uses the $36 dividend payment to buy 1.866 additional shares of stock. 

Q2 of 2009 rolls around, and Pitney Bowes announces another .36 cent dividend. But now Adam has 101.86 shares of stock, so this quarter his payment is $36.67. At this time, the price of Pitney Bowes stock has risen to $22.24 a share. Now his dividend payment buys him 1.648 shares of stock. After the Q2 dividend payment he has 103.508.

In Q3, Pitney Bowes announces yet another 36 cent dividend payment per share. This time his dividend payment is 37.26 and that earns him another 1.662 shares at $22.42 price per share. He ends Q3 with 104.74 shares.

In Q4, Pitney Bowes announces another 36 cent dividend payment. And Adam gets 37.70 and adds 1.620 shares to his account. Now he has 105.36 shares to end 2009. He hasn't paid a penny in commissions to his broker, so more of his money is working for him.


Pitney Bowes Example

Shares Owned
Quarter
Dividend
Dividend Paid
Share Price
Shares Added
100
Q1 2009
0.36
$36
19.26
1.866
101.86
Q2 2009
0.36
36.67
22.24
1.648
103.508
Q3 2009
0.36
37.26
22.42
1.662
104.74
Q4 2009
0.36
37.7
23.27
1.62
105.36
Q1 2010
 
 
 
 
This chart shows how a person can grow their stock portfolio through DRIP investing. The stock used for this example was from actual data on Pitney Bowes stock.

Dividend Stocks Use Compounding to Earn You $$$

There's no magic to dividend stocks, just math. The principle behind dividend investing is compounding. The more shares you own, the more dividends you get, the more shares are added to your stock portfolio.

I liked the video to the left, because this investor is clearly very enthusiastic about dividend investing, as am I.

Is dividend investing fool proof? No. Absolutely not. Many dividend investors have been burned by the financial meltdown of 2008-2009. Bank and financial stocks are famous dividend payers, and these stocks have plummeted in price, and halted dividend payouts. But a down market can still be a good time to buy dividend stocks. I think certain bank stocks are excellent potential future dividend payers, and many are on sale. If you are going to buy using this strategy, I strongly encourage you to diversify. Don't invest in only one or two stock sectors. About 3/4 of my retirement portfolio is invested in highly diversified index funds. 

How Do I Set Up a DRIP?

Some dividend reinvestment programs are administered directly through the stock companies themselves, but some self-directed investment brokerages, like TDAmeritrade allow you to set up commission-free drip systems while holding shares in their investment accounts. 

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Comments 15 comments

Ann Nonymous profile image

Ann Nonymous 6 years ago from Virginia

Good job explaining it, wannabwestern! I really like that you inserted a picture of money growing on a tree....If only!


Hello, hello, profile image

Hello, hello, 6 years ago from London, UK

A great explanitory hub. Thank you for all these tips.


dahoglund profile image

dahoglund 6 years ago from Wisconsin Rapids

I wish I had this information when I was young.


wannabwestern profile image

wannabwestern 6 years ago from The Land of Tractors Author

Thanks Ann! I liked that picture too! :)

Hello, hello, thank you so much.

dahoglund, I know what you mean. I wish I had fully understood this principle when I was young too. When I was young, I made the foolish mistake of listening to a stock advisor instead of following my gut on a stock purchase. It was 1994 and I had received a small inheritance and wanted to buy $5,000 worth of Microsoft and Apple stock. But the advisor told me these were speculative buys and dissuaded me, and instead bought me STRIPS Bonds. If I had bought those stocks I would have been a Microsoft milliionaire by the age of 30-or at least well on the way. That's why I'm such a big finance nut. I have some regrets of my own.


Springboard profile image

Springboard 6 years ago from Wisconsin

Very good and sound advice, and I should say that for anyone, if your strategy is buy and hold for the long term, by far this is the best way to go. Not having to pay sales loads or maintenance fees on mutual funds, or commissions on stock trades really helps, especially if one is a smaller investor.

One might want to try ShareBuilder as well. It allows you to build shares, reinvest dividends, commissions are very very low, and you have slightly better liquidity. If the stock does something you don't like you can get out of it immediately. Drips tend to take longer to liquidate and by that time the stock could be worth far less.

Job well done. A great hub.


wannabwestern profile image

wannabwestern 6 years ago from The Land of Tractors Author

Thanks Springboard. If you are planning to park your funds in an IRA at an investment company like Sharebuilder, I would just add that people should do some research to find out what that company's policy is on DRIPS. Some companies will hold your DRIPS for you, while others will not.

Thanks for your sincere praise. I am truly honored by your comment.


Cathi Sutton profile image

Cathi Sutton 6 years ago

Thanks for the good info and advise!


Stocks Duniya 6 years ago

The info given is Very good and sound advice, and I have to say that for anyone, if your strategy is buy and hold for the long term, by far this is the best way to go. Not having to pay sales loads or maintenance fees on mutual funds, or commissions on stock trades really helps,

Stocks Duniya Team


wannabwestern profile image

wannabwestern 6 years ago from The Land of Tractors Author

Thanks Cathi and Stocks Duniya. I am a buy and hold investor and this strategy is working for me. Thanks for your comments!


mandatory retirement 6 years ago

I was really able to understand DRIP. Your Pitney Bowes sample was excellent. Finally, I looked for a topic, found a relevant article and was able to understand it. Thanks.


wannabwestern profile image

wannabwestern 6 years ago from The Land of Tractors Author

Thanks mandatory retirement, I appreciate your comment. This isn't a complicated concept to master but it does catch people up sometimes. Regards.


AllSuretyBonds profile image

AllSuretyBonds 5 years ago

Nice Hub. This is very informative information for someone who is looking to know more about a Dividend Reinvestment Plan.


wannabwestern profile image

wannabwestern 5 years ago from The Land of Tractors Author

Thank you AllSuretyBonds!


Hypersapien profile image

Hypersapien 4 years ago

DRiPs are fantastic. If you get started when you're young, you'll be pleasantly surprised at where you'll be in 20 years.


wannabwestern profile image

wannabwestern 4 years ago from The Land of Tractors Author

I agree. If only we all knew this at a younger age. Most people don't become interested in investing until they are really ready to begin planning for retirement.

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