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