- Personal Finance
Stocks 101: What is a Dividend Reinvestment Plan or DRIP?
Investing in DRIPs
Several types of securities pay dividends. For the purpose of this article, I will refer to stocks as I discuss dividends and describe how DRIPS work, because well, it's just easier to focus on one security type. The main focus of this article is to discuss dividends and DRIP investing, and to explain how the power of compound interest and time-value of money can grow your investment nest egg over time. But before we get to that, let's first define dividends and identify several types of investments that pay investors income on a periodic basis.
Dividends Use Compounding to Earn Income
What is a dividend?
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, usually four times a year, after a company releases its' quarterly earnings statements. As a company makes income, it can pass some of its earnings onto its shareholders, the owners of that company's stock. Not all companies offer dividends to its stockholders. And some companies pay dividends once a year or once a month, but the most typical arrangement is to pay out quarterly dividends. Typically, companies that do not pay dividends are considered growth stocks, and investors make money on growth stocks through the appreciation of the share price.
Stocks in companies that pay dividends are known as income stocks, because the stock creates income for the investor. Ideally, any income stock you purchase will keep a stable stock price, but sometimes a stock is considered a hybrid--both a growth and income stock. In my opinion, these stocks are the best of both worlds, but as is the case with all stock investing, there's inherent risk in investing in any type of stock.
If you are buying income stocks, an essential step is to reinvest these dividend payments into more shares of stock, using a dividend reinvestment program or DRIP. Income-earning investments can be appealing to retirees, because if a portfolio is large enough, it can act as its own dividend money tree, paying retirees regular payments on a quarterly basis.
Before an investor adds a dividend-paying stock to their portfolio, they should do some research on the health of the company and its ability to pay the dividend to its investors. While there are many factors affecting profitability, and yesterday's performance is never a promise for the future, if a company does not earn enough income on a yearly basis to pay its investors' dividends AND keep some profit to reinvest in the business' costs, then it will not typically be a viable selection, and the company's share price may lose value. If you have an income-based portfolio, having solid, boring companies that pay dividends is usually better than searching for companies that pay really high, unsustainable dividend payouts.
What types of investments pay out a dividend?
Several types of investments are structured to pay its investors part of their earnings in the form of dividends or distributions. Note that all investments should be thoroughly researched. The purpose of this article is not to offer investment advice to individuals.
As part of a balanced retirement strategy, stocks, mutual funds, Exchange Traded Funds (ETFs), REITs, BDCs, and other income-paying investments in a well-diversified portfolio can become a source of passive income. Modern Portfolio Theory says that for individual investors, owning individual stocks is riskier that owning mutual funds, which are investments that pool investors' money together to buy shares of stocks, and sometimes bonds and other securities, to meet a defined investment objective. Mutual funds spread the risk that companies will perform well across a pool of several stocks and other investments held within the fund.
Stocks are shares of ownership in a company. Stocks that include a dividend payout are called income stocks.
Dividends are usually paid quarterly. Earnings statements for companies are made on a quarterly basis, and usually dividends are paid within a period of weeks following the earnings reports. Not all companies report their earnings in the same 4 months out of the year. Companies' earnings periods are staggered throughout the year. So the earnings periods for one company may not be during the same months as other companies in your portfolio, allowing for a staggered and consistent stream of passive income in a portfolio.
Keep in mind that sometimes companies experience poor earnings results, and they can choose not to pay a dividend to their investors. Company management is not required to pay a dividend, if it isn't good for the business and its investors, and will sometimes make the choice to stop paying dividends. During the financial crisis of 2008-2010, many American banks that were well-known and generous dividend payers stopped paying dividends. Wells Fargo and Bank of America are examples of companies that used to pay high dividends to its investors, then stopped paying dividends, and are now paying dividends again, though at a reduced rate.
Sometimes companies will unwisely continue to pay dividends to its investors because stopping dividends is considered a market signal that the company is in trouble, and income-oriented investors may decide to sell a stock that is no longer producing income.
Mutual funds are an investment that contains a professionally-selected portfolio of stocks that is managed by an investment advisor. Investors money is pooled together to purchase stocks, bonds, treasuries, and any other securities defined by the investment team in a prospectus. Mutual funds can be actively managed, or set up to follow an investment index. Mutual funds, if managed well, are thought to carry less investment risk than individual companies because the investment performance of the companies within the portfolio will be the sum of profits and losses of all the companies in the fund. Investors are often required to pay a fee to buy and sell shares of a mutual fund, and a small fractional percentage is taken out as a yearly management fee to the investors. Mutual funds that incorporate income stocks will often pay a dividend to its investors, who can reinvest this money to buy more shares.
REITS or Real Estate Investment Trusts
Real Estate Investment Trusts are investments, like mutual funds, that pool the assets of many investors to buy a portfolio of real estate holdings, which are often income-producing properties and assets. REITs can create business returns by buying and leasing properties, collecting rents, and through the appreciation of the properties in the portfolio. Some REITs contain telecommunications holdings, such as cell phone towers. REITS usually pay out a dividend. Some REITS pay out a monthly dividend as they collect monthly rent payments. REITS as an investment are subject to market conditions and are affected by rising interest rates. Most stock advisors do not recommend overloading a portfolio with REIT investments. This can be a temptation for income investors, because REITs can sometimes pay much higher dividends than income stocks, and their share prices tend to be highly cyclical.
BDCs or Business Development Companies
BDCs are a type of corporation that is subject to a different set of government regulations that the typical corporation. BDCs invest in small businesses and contain an investment portfolio of these business investments. These companies are regulated by the United States government and required to pay 90% of their business earnings to investors. BDCs are regarded as high risk investments, but their high-interest dividend payouts attract many investors. Investopedia's article on BDCs says these investments are prone to sudden sharp drops in valuation, which is not desirable for a buy and hold investor.
Other Income Investments
Other income investments include Corporate Bonds, T-Bills, and Government Savings Bonds. These fixed-return investments generally pay an investor a promised fixed return for loaning principal that is paid back with interest over a set time period. The income from these investments can be reinvested using the same ideas as income stocks, but since they are a different kind of investment altogether, I will not address them here in this article.
How Do Dividend Payments Work
Usually dividends are announced quarterly, after each earnings period. It is common practice for companies to pay quarterly dividend payments, after the company publicly announces its earnings. It will then publish an ex-dividend date, or the date an investor has to purchase stock to be qualified to receive a dividend payment. If you are a buy-and-hold investor, you will receive your dividends quarterly after you purchase the stock until you sell it.
Usually the company will deposit your dividend payment in whatever investment account you are using to hold your stock investment.
Why Drip? Sidestep Costly Trading Fees with Automated Reinvestments
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 $7 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 $7 in and $7 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.
Drip, drip, drip...
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 Money
There's no magic to dividend stocks, just math. The principle behind dividend investing is compounding and time. The more shares you own, the more dividends you get, the more shares are added to your stock portfolio.
Is dividend investing fool proof? No. Absolutely not. Many dividend investors were burned by the financial meltdown of 2008-2009. Bank and financial stocks are famous dividend payers, and these stocks 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 three quarters of my retirement portfolio is invested in highly diversified, boring index funds.
How Do I Set Up a DRIP?
Some dividend reinvestment programs are administered directly through the stock companies themselves, but as self-directed investment brokerages have become a mainstream option for everyday investors like you and me, you can usually set up commission-free DRIP systems as a feature of holding shares in a self-directed investment account. Setting up a DRIP in an IRA or 401K account is sometimes as locating the term DRIP in the account's settings. Often you simply have to select it as an option during the account setup phase.
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© 2010 Carolyn Augustine