HOW MUCH? Dividend Reinvestment Plans

Why Dividend Reinvestment Plans (DRIPs) Make Great Investments?

   
 

In our last article we introduced the idea of the DRIP and explained the three (3) types of DRIPs that are available. Now we will explore the factors that make DRIPs great investment plans, analyzing just a few of the short and long term benefits.

Short Term Advantages of Dividend Reinvestment Plans

Let's say that you have $25 per month to invest. You could deposit into your local friendly savings bank and earn the regular interest rate. Now the advantages to this are of course that the principal amount of your investment is guaranteed to be there when it comes time to withdraw the money. The downside of that of course is that it's not going to grow very fast as part of your retirement planning.

If you have $25 per month to invest and decide to invest it in a stock plan, chances are that you're not going to find that many stocks that are selling for $25 or less (since you have to pay fees, commissions, etc.) that have any type of solid business behind them. However, if you invest in a DRIP plan you have the advantage of having companies with "brand" names that will allow you to invest not only the $25 per month but any/all dividends that the company is paying.

Another advantage to the $25 per month investment plan in a DRIP is that you are not limited to stocks that sell for $25 or less per share because chances are you're paying no (or very minimal) investment fees, and because you can purchase what are called "fractional" shares (i.e. less than one) of the stock.

Long Term Advantages of DRIPs

The long term benefits of a DRIP are really very simple. Let's say that you purchase one (1) share of a $75 stock to start off your DRIP. Next month the stock drops to $50 (this is of course an exaggeration since most stocks won't drop this low this quickly) - when you add your new investment (let's assume it's $50) then your cost basis for the shares that you've purchased drops.

How does the cost basis drop? If I paid $75 isn't that my cost basis? Not exactly - this is called dollar cost averaging. Let's use a table to show you how this works:

Month Share Price Investment Shares Purchased Total Cost Avg. Cost Per Share
January $75.00 $75.00 1.000 $75.00 $75.000
February $50.00 $50.00 1.000 $125.00 $62.500
March $55.00 $50.00 0.909 $175.00 $60.156
April $57.00 $50.00 0.877 $225.00 $59.425
May $58.00 $50.00 0.862 $275.00 $59.161
June $59.25 $50.00 0.844 $325.00 $59.174
July $61.75 $50.00 0.810 $375.00 $59.505
August $62.85 $50.00 0.796 $425.00 $59.880
September $67.85 $50.00 0.737 $475.00 $60.630
October $69.95 $50.00 0.715 $525.00 $61.409
November $71.25 $50.00 0.702 $575.00 $62.156
December $75.00 $50.00 0.667 $625.00 $63.019

DRIP Investments
© iStockphoto.com - raalves

Assuming that you did not have a DRIP you would have only had one (1) month where you could have purchased a full share in this particular stock. Admittedly we took some liberties with the stock prices in order to demonstrate how this would work and how fractional shares would add up. At the end of this year, you would own 9.918 shares of stock and your average price on those shared would be $63.02. Let's assume that you immediately decided to sell the shares that you owned (again this isn't recommended as the point of a DRIP is long term investment - you now have $743.85 in stock versus your original cost of $625 or an increase in just over $118 from your initial investment (before fees). Stop and consider the power of this over the course of several years of investing only $50 per month!

No Guarantees

Do not make any mistake about this - like any stock a DRIP has risks associated with it including losing your entire investment. Another word of caution is many brokers recommend diversity in your portfolio - but you certainly have the option of being able to invest in a DRIP for multiple companies. Moreover, you should consider your 401k investment options as another powerful way to diversify.

Summary

A DRIP is a good way to invest small amounts of money regularly. The longer you are willing to hold onto stocks the better the chance of a return. While no stock is guaranteed to increase in price, one benefit of a DRIP is the ability to use dollar cost averaging. There are many other benefits to the DRIP investor, in both the short and long term, and I'm really looking forward to discussing them in future articles.

Related topics: Introduction to DRIPs

 

 

 

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