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Stocks 101: What is a Dividend Reinvestment Plan or DRIP?

Carolyn is a self-taught investor. She is also a mom, photographer, and lover of art and literature. She is not an investment professional.

Money doesn't grow on trees, but it can grow in your portfolio when you buy dividend-paying securities and then reinvest them using a DRIP.

Money doesn't grow on trees, but it can grow in your portfolio when you buy dividend-paying securities and then reinvest them using a 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 the power of compounding to create a passive income stream from investments.

Dividends use the power of compounding to create a passive income stream from investments.

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

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

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...

DRIPs or dividend re-investment programs are an important part of an investment portfolio containing dividend-paying securities.

DRIPs or dividend re-investment programs are an important part of an investment portfolio containing dividend-paying securities.

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

This chart shows how a person can grow their stock portfolio through DRIP investing. The stock used for this example was from actual data on Pitney Bowes stock.

Shares OwnedQuarterDividendDividend PaidShare PriceShares Added

100

Q1 2009

0.36

$36

19.26

1.866

101.86

Q2 2009

0.36

36.67

22.24

1.648

103.508

Q3 2009

0.36

37.26

22.42

1.662

104.74

Q4 2009

0.36

37.7

23.27

1.62

105.36

Q1 2010

 

 

 

 

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.

More Hubs Featuring Dividend Reinvesting

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© 2010 Carolyn Augustine

Comments

Carolyn Augustine (author) from Iowa on February 07, 2012:

I agree. If only we all knew this at a younger age. Most people don't become interested in investing until they are really ready to begin planning for retirement.

Hypersapien on February 02, 2012:

DRiPs are fantastic. If you get started when you're young, you'll be pleasantly surprised at where you'll be in 20 years.

Carolyn Augustine (author) from Iowa on March 10, 2011:

Thank you AllSuretyBonds!

AllSuretyBonds on March 10, 2011:

Nice Hub. This is very informative information for someone who is looking to know more about a Dividend Reinvestment Plan.

Carolyn Augustine (author) from Iowa on September 14, 2010:

Thanks mandatory retirement, I appreciate your comment. This isn't a complicated concept to master but it does catch people up sometimes. Regards.

mandatory retirement on September 13, 2010:

I was really able to understand DRIP. Your Pitney Bowes sample was excellent. Finally, I looked for a topic, found a relevant article and was able to understand it. Thanks.

Carolyn Augustine (author) from Iowa on April 04, 2010:

Thanks Cathi and Stocks Duniya. I am a buy and hold investor and this strategy is working for me. Thanks for your comments!

Stocks Duniya on April 02, 2010:

The info given is Very good and sound advice, and I have to say that for anyone, if your strategy is buy and hold for the long term, by far this is the best way to go. Not having to pay sales loads or maintenance fees on mutual funds, or commissions on stock trades really helps,

Stocks Duniya Team

Cathi Sutton on March 18, 2010:

Thanks for the good info and advise!

Carolyn Augustine (author) from Iowa on February 04, 2010:

Thanks Springboard. If you are planning to park your funds in an IRA at an investment company like Sharebuilder, I would just add that people should do some research to find out what that company's policy is on DRIPS. Some companies will hold your DRIPS for you, while others will not.

Thanks for your sincere praise. I am truly honored by your comment.

Springboard from Wisconsin on February 03, 2010:

Very good and sound advice, and I should say that for anyone, if your strategy is buy and hold for the long term, by far this is the best way to go. Not having to pay sales loads or maintenance fees on mutual funds, or commissions on stock trades really helps, especially if one is a smaller investor.

One might want to try ShareBuilder as well. It allows you to build shares, reinvest dividends, commissions are very very low, and you have slightly better liquidity. If the stock does something you don't like you can get out of it immediately. Drips tend to take longer to liquidate and by that time the stock could be worth far less.

Job well done. A great hub.

Carolyn Augustine (author) from Iowa on February 01, 2010:

Thanks Ann! I liked that picture too! :)

Hello, hello, thank you so much.

dahoglund, I know what you mean. I wish I had fully understood this principle when I was young too. When I was young, I made the foolish mistake of listening to a stock advisor instead of following my gut on a stock purchase. It was 1994 and I had received a small inheritance and wanted to buy $5,000 worth of Microsoft and Apple stock. But the advisor told me these were speculative buys and dissuaded me, and instead bought me STRIPS Bonds. If I had bought those stocks I would have been a Microsoft milliionaire by the age of 30-or at least well on the way. That's why I'm such a big finance nut. I have some regrets of my own.

Don A. Hoglund from Wisconsin Rapids on February 01, 2010:

I wish I had this information when I was young.

Hello, hello, from London, UK on February 01, 2010:

A great explanitory hub. Thank you for all these tips.

Ann Nonymous from Virginia on February 01, 2010:

Good job explaining it, wannabwestern! I really like that you inserted a picture of money growing on a tree....If only!