The following is a guest post from Dan@StockTrades.ca
Dividend stocks at one time or another will more than likely become the backbone of your investing portfolio. Especially in your later years, the passive income from your dividend investments can play a pivotal role in your retirement. But if you are a young aspiring investor with a keen eye on early retirement, what is the best thing to do with that dividend check? In my honest opinion, it’s setting up a DRIP plan.
So what exactly is a DRIP plan?
A DRIP, or dividend reinvestment plan is a system set up by your broker,company or financial institution to purchase more stocks with your dividend payouts. The shares are purchased in fractions if your dividend payout is not enough to purchase a whole share. The best way to imagine this is a bucket stopping a leak. Every time water “drips” into the bucket, it fills. Once the bucket is full, you’ve earned a share in that company. You dump the bucket out, and repeat the process.
What Are The Benefits Of A DRIP program in my portfolio?
There are a multitude of benefits involved with signing up for a DRIP program with your broker. By the end of this article you will probably see why having your dividend payments dripping back into the stocks you own is a no brainer for the large majority of investors. I’ll highlight my top 4 reasons for setting up a DRIP program in this piece. Let’s get to it.
- There are no commissions
When you sign up for a DRIP program, your dividend payments are used to purchase a fraction of a stock, or a whole stock if your payments are big enough. The best part about this? You aren’t charged a commission. Say you receive a $50 dividend quarterly from company X, which trades at $100. Hypothetically lets say the price of the stock doesn’t move, and your brokerage charges you $5 dollars a trade. You could either:
- a) Wait until the end of the year and pay $205 to purchase 2 stocks in company X.
- b) DRIP the $50 every quarter and own 2 stocks in company X for $200.
This may not seem like much, but that commission in this situation would eat up 2.5% of your dividends received from that stock that year.
- Automatic Dollar-Cost Averaging
If you are unaware of what dollar cost averaging is, I will give a little explanation. Dollar-Cost Averaging is an investment strategy used by a large number of investors. The premise of this method is to buy a certain dollar amount of company X each month, regardless of the price. So if an investor allocates $1000 a month to invest in company X, at $20 a share the investor is buying 50 shares a month. If the price of the stock goes up to $25 a share, the investor is purchasing 40 shares a month. The average price of the shares would therefore be $2000/90, or $22.22.
DRIP programs provide somewhat of an automated system of DCA. When the price of a share goes down, your dividends will be able to purchase larger fractions of the stock and vise versa, therefore providing you with an above average cost per share. If you aren’t using Dollar-Cost Averaging, I highly suggest you check out this article that explains it more in depth.
- Companies may offer discounts
There are companies out there that actually provide you with discounted stock prices if you sign up for their DRIP program. These discounts can be anywhere from 1-5%, and although it may not seem like much in the short term, you will see considerable benefits over the life of your investment portfolio. DripPrimer.ca provides a great list of companies that offer discounts here.
Companies often do this because it gives shareholders incentive to become buy and hold investors for the long term. DRIP shares are often purchased directly from the company and not from a stock holder, so you can see the benefit it provides to them, hence the discount they offer.
- Compounding starts immediately
An investor collecting dividend cheques that is not signed up for a DRIP program may choose to wait until their account balance hits a certain amount before purchasing more stocks. This makes a lot of sense. A $5 commission payment on a $200 payment is 2.5% of your total return eaten up in fees.
What investors will often do is wait until their balance reaches a certain point where the commission doesn’t seem to hurt as bad. An investor making $200 a month in dividend income may wait until their balance reaches $1000 before purchasing more stocks. The downfall of this is that this money is sitting idle in their account earning next to nothing. With a DRIP program, your money goes to work immediately and begins to compound, creating what we call the snowball effect. Sure Dividend has a great article that goes over the power of the snowball effect.
Overall, for Most Investors A DRIP Program Is A No Brainer
For younger investors just starting out with dividend investing, not signing up for a DRIP program is just costing you money. Assuming your strategy is to build wealth, you have no need for the dividend payments as cash, and it would be better off reinvested into the company to compound and grow.
For an older investor who is looking to retire in the near future, a DRIP program may not be the best option if you are planning to use your dividend payments to supplement your income. This may be a situation where you’d rather have the cash to provide a flow of passive income in retirement.
Contact your bank or broker and find out if they offer a DRIP program. The large majority of the institutions these days provide them. I currently use Questrade, and signing up for their DRIP program was as simple as filling out a single form. Be aware though, that some brokers may not be able to purchase fractions of shares, and you may have to wait until you have significant funds to purchase a whole share.
Author Bio: Dan Kent is a writer and co founder of Stocktrades.ca. A DIY investor for 7 years now, Dan has a combination of dividend, growth and real estate investments in to his portfolio and is looking to continually grow his net worth. You can check his website out at stocktrades.ca or follow him on Twitter at @Stocktrades_CA