A dividend reinvestment plan, or DRIP, may go by a rather unimpressive acronym, but investors shouldnt make the mistake of thinking this strategy is all wet.

The truth is that a dividend reinvestment plan can help power significant outperformance over traditional investing strategies for the long term.

What exactly is a DRIP, and, more importantly, how does it work for long-term income investors? Well break it down here one term at a time so that it makes perfect sense:

  • What is a DRIP?
  • A closer look at DRIPs and compound interest.
  • The drawbacks of using a DRIP.

What Is a DRIP?

First, investors buy into stocks that pay dividends. Dividends are regular profit-sharing payments to shareholders, typically delivered once each quarter.

As long as a company has some kind of dividend program, you will get a fixed payment for each share you own.

Some of the oldest and most reliable income stocks to buy are called dividend aristocrats. Dividend aristocrats are companies listed in the S&P 500 with a track record of 25 years worth of increasing dividend payments to investors.

Second, reinvestment means that you deploy those dividends in your investing strategy and buy even more shares rather than taking that money and spending it elsewhere. So even if you only start with 100 shares of a given stock today, you may have 105 shares in a year or two – or 1,500 shares eventually if youre patient.

A DRIP, then, is a simple way to immediately deploy cash in this manner so you dont have to watch your bank account, then manually purchase a handful of additional shares after you get paid. Plenty of investors do this on their own, as hundreds of stocks and funds offer direct DRIPs to investors. On top of that, many online brokerage platforms also offer support for automated dividend reinvestment plans. So chances are if a stock has a dividend, you can set up a DRIP.

If youre looking to strike it rich quickly on Wall Street, then a DRIP may not be right for you. But if youre after a long-term and lower-risk approach to investing, dividend reinvestment plans allow you to steadily accumulate more and more shares – without using any additional cash out of your own pocket.

A Case Study in DRIPs and Compound Interest

Using telecom giant AT&T (ticker: T) as an example, lets crunch some numbers to show how this strategy works.

AT&T stock was trading at about $29 in 2011. So lets say you invested $2,900 and purchased 100 shares.

The stock paid four 43-cent dividends on a quarterly basis that year, for a total of $1.72 per share. Thats good for a 6% dividend yield as you get paid back 6% of the purchase price of your stock ($29, as stated previously) over the course of the years dividend distributions (43 cents x four quarters = a total of $1.72).

With 100 shares, the math is simple and adds up to $172 that you would have received in dividends on your specific investment of $2,900 in this example. That amount would buy you almost exactly six extra shares of stock. So instead of a 6% cash payment, youre getting a 6% payment in stock (six shares from your initial investment of 100).

Thats a lot of math, but heres where it gets really interesting. Take your 106 shares that you have at the beginning of 2012 and then add 6% more to get 112.36 – and yes, believe it or not, many brokerage platforms and dividend reinvestment plans allow for fractional shares. Then take 112.36 in 2013 and add 6% and you have 119.1 shares.

After you fast-forward to 2021, that 6% has compounded over 10 years to give you a total holding of 179.1 shares from your initial investment.

This is whats called compound interest because the interest payment you get one year makes next years interest payment even larger, and so on. Legendary investor Warren Buffett has used compound interest to build up billions of dollars in wealth.

You have to be patient to reap the benefits of compound interest, but as you can see, this is a powerful way to increase your holdings without coming up with additional seed capital.

The Drawbacks of Using a DRIP

For long-term investors, dividend reinvestment plans may make sense. That said, there are a few drawbacks that must be acknowledged.

For starters, you have to look closely at what vehicle youre using for a DRIP. Some big-name blue-chip stocks offer reinvestment programs but also charge you fees of $5 or $10 per transaction. That doesnt sound like much, but unless you have huge holdings, youre likely only reinvesting a few hundred bucks – and besides, the name of the game is compound interest, so every penny you pay in fees now subtracts from your long-term return later.

Also consider that even though DRIP investors do not receive cash dividends, they are still subject to taxes. Thats because technically youre not being paid in stock but an actual cash dividend that is immediately reinvested.

If youre going to get taxed anyway, then some investors prefer to take control of the cash and make informed decisions based on the current marketplace rather than continue to double down on existing holdings. The aforementioned example of AT&T is relevant here, as the shares have drifted steadily lower in recent years. If you had simply taken the cash and bought something else, you may have done better than sticking with a DRIP.

And perhaps most obviously, if you want or need the cash from your dividends for anything else, you have to take the trouble to unplug the dividend reinvestments. Many retirees rely on dividend income to pay their day-to-day expenses, and other investors simply like to have the cash for a vacation or for emergency funds. Automating a DRIP makes it simple for your nest egg to grow, but it makes it difficult for you to fund other expenses as needed.

As with so many kinds of investment vehicles, a DRIP depends on your personal goals and the specific stock in which youre pursuing a dividend reinvestment plan.

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