What is Drip Investing
DRIP stands for Dividend Reinvestment Plan. Unlike most complicated investing terms, the definition for DRIP is self-explanatory. In DRIP, dividends earned will be reinvested. Dividends will earn dividends in future and the power of compounding comes into play. You will see an example of compounding later in this post. First, let us see the mechanics behind DRIP.
How DRIP Investing Works
Let us see an example for dividend reinvesting schemes. Assume you have $20,000 dollars to invest. Let a company ‘XYZ’ issue DRIP shares worth 10$ each. If you invest all your money in XYZ, you will own 2000 shares.
Let the company declare a dividend of $0.5$ per share at the end of the first year.
If you had invested in a conventional share, the dividend will be credited to your account. The scenario is different in case of DRIP shares. You will see how.
The total dividend on your investment is
0.5$ per share x 2000 shares = $1000.
Now your thousand dollars will be reinvested in additional shares. The company will add a proportional number of shares for $1000 to your account.
In our example, since each share is worth $10. you will now own
$1000 / $10 = 100 shares. Hence after 1 year, your portfolio will be having 2100 shares.
The numbers used in our example gave rise to a ‘whole number’ (100) of additional shares. In reality, often your dividends will earn a fractional number of shares. For illustration, let us assume a different dividend value and share price.
Let the dividend be 0.6$ per share. Let the share price after a year become $11 (, an increase by 1$).
Dividend on original 2000 shares =
2000 shares x $0.6 = $1200.
When reinvested, $1200 can buy $1200/$11 = 109.09 number of shares.
You just saw an important difference of DRIP shares compared to the normal ones. In the case of normal shares bought on exchanges, purchase of a fractional number of shares is not possible. But in DRIP, you can add a partial number of shares to your portfolio.
Is there any advantage of buying fractional shares through DRIP? Instead can’t you just wait and buy whole shares? You will see an example that will help you understand an advantage of “instant” partial shares.
Assume, you hold 10 DRIP shares of a company at $1000 per share. Assume after one year you get a dividend of $100 per share. Let the price for the following year be $1200 per share.
Now, your total dividend will be $100 x 10 = $1000. This amount will immediately get reinvested. The number of additional shares you will receive will be $1200/$1000 = 1.2 shares.
So, you will be holding a total of 10 + 1.2 = 11.2 shares after the first year. If you had bought the same shares via a normal account, the dividend amount of $1000 will be sitting idle in your account (unless you invest somewhere else). With DRIP plan, the additional income instantly gets an opportunity earn more for you.
7 Benefits of Dividend Reinvestment Plan
DRIP plans have several benefits especially for long-term investors who have spotted good companies. A few notable advantages are the following.
1 Power of Compounding
The primary benefit of DRIP investing is the power of compounding. By getting reinvested, dividends add to your capital and in turn earn dividends in future. This process helps your money grow exponentially even if the share price of the company grows linearly.
To illustrate the above point, here is an example. This example compares the growth of net worth for shares invested and not-invested in DRIP.
Assume you start a DRIP by buying 500 shares each worth $10. Let the dividend per share at the end of year one be $1.2. So you will receive 500 x $1.2 = $600 in dividends. This amount will be reinvested and will be used to buy additional shares. The process continues for the next 6 years.
|Year||Additional Shares||Total Shares||Share Price||Div. Per Share||Dividend|
In the above example, we have deliberately used a linearly increasing share price. Other values like dividend per share are imaginary numbers. Now let us compare the net worth of a person chosen DRIP to a person who hasn’t reinvested the dividends.
|Shares In DRIP||Shares When Not In DRIP||Share Price||Net worth||Net Worth Without Reinvesting|
Below diagram compares the growth of net worth with and without DRIP. (The numbers are from the above example.)
As you can see in the above figure, the DRIP net worth has grown exponentially.
2 Suits Long-Term Investing
Dividend reinvestment is great if you are not a busy day trader but a value investor. You are an investor who has seen value in a handful of company stocks. You want to stay invested for longer. You hope the stocks will appreciate with time and will gain handsomely in long term. In such cases, DRIP investing will suit your investment philosophy.
As a long-term investor, since you are already convinced of accumulating in a company, you never have to wait for buying additional shares. DRIP can automate the accumulation process.
3 You Don’t Have to Time the Market
Timing a stock market is difficult if not possible for most investors. Also, good companies have higher PEs than the recommended levels by experts. High PEs is a result of market hope of consistent future growth (even an expectation of exponential growth). Difficulties in analyzing and high PEs make timing a daunting task.
With DRIP, you never have to time the markets. Once you start with a reasonable price, your net worth grows steadily from there.
4 Dollar Cost Averaging
If you have invested longer through DRIP, you will enjoy price benefits due to “dollar cost averaging”. You will understand this concept after seeing the below example.
Assume, you start by purchasing 100 shares each worth $100. Let the dividend at the end of the first year be $2 per share. The dividend you will receive will be
100 x $2 = $200. Let the share price for the following year be $120. With the $200 income, your portfolio will now get an additional 1.67 shares ( $200/$120).
Thus total holding in your portfolio becomes 101.67 shares. The process continues for the next 6 years. We have assumed imaginary values for share prices and dividends per share.
|Years||Additional Shares||Number of Shares||Share Price||Dividend/Share||Dividend|
At the end of 6 years, you will be holding 108.79 shares. The market price is 178 dollar per share after 6th year. But you would have paid a much lesser price compared to one who buys the same number of shares at the sixth year. Your share price can be calculated as shown below.
Your total investment is nothing but your initial purchase amount for the 100 shares in the first year.
Thus, your investment =
100 shares x $100/share = $10000.
Total shares you hold at the end of year six is 108.79.
So your effective share price is
$10000/108.79 = $91.9. But, the market price is $178! Your price is lower than the market price at about 48.3%.
You just saw a benefit of dollar cost averaging. Since your investments are distributed over time, most often you will be paying a much lesser price than the rest. (Unless the company performs very badly.)
5 Zero or Less Fee
DRIP shares are normally bought directly from the issuing companies. Generally, no middleman or stockbroker will be involved. Hence, you need not pay commissions for every transaction.
Note: You can simulate DRIP investing by manually reinvesting the dividend. But, you have to pay commissions for every transaction. But this fee is absent in DRIP!
6 Peace of Mind
Stress is a major risk factor for traders. There have been numerous studies that relate frequent trading and stress. For example, a study published in PNAS (Proceeding of the National Academy of Sciences of the United States of America) is a proof of two things.
- Traders are at a risk of higher levels of Cortisol (stress hormone.)
- Traders overreact to minor risk factors.
Bottom line is, frequent trading is not good for health – both physical and mental.
In DRIP, you do not have to keep watching tickers like day traders. DRIP investing plans work without your intervention. If you are good at finding good companies with proven track records, you are done. Finding a solid company is the only difficult task you have to do. You don’t have to worry about daily price movements and even market crashes (courtesy, “Dollar Cost Averaging”). Peace of mind is a major benefit of DRIP investing.
7 Share Price Discounts
DRIP shares are often sold at a discount from the market price. Combined with “dollar cost averaging”, you will get more value for your investments. In the example, we just saw for the explanation of dollar cost averaging, assume the company is offering a discount of 10% on shares. Then the table will look like as shown below.
|Years||Additional Shares||Number of Shares||Share Price||Discounted Share Price||Div./Share||Dividend|
With 10% discount, your holding will be 109.80 shares instead of 108.79 shares without discount. Thus a reduction in market price has enabled you to earn an additional (109.80 – 108.79 =) 1.01 shares. This is a kind of “bonus” for choosing DRIP investing over normal stocks.
Simulated DRIP Investing
In some cases, a stockbroker may offer a simulated DRIP. In that case, your broker will reinvest the dividends to purchase further stocks.
Some potential drawbacks of a simulated DRIP plan are the following:
- You may not receive a discount on market price.
- You will not be able to buy partial shares.
- Fee may be higher compared to direct company plans.
Do you have to pay taxes on DRIPs?
Though all your dividend income gets reinvested, still the income is taxable. You have to pay taxes.
As far as capital gain tax is concerned, you will be paying only when you exit the plan. Since most investors opt for DRIP for a long-term, capital gain taxes will be on the lower end. As a general rule, longer the term, lesser will be the capital gains tax.