May 29, 2015
Through the right investment strategy , a good dividend yielding company that can be a long term bet is identified. The company can then be a part of the investment strategy, the Dividend Reinvestment Plan, better known as DRIP. This strategy is for the company that you have conviction in to hold for a reasonably longer duration. Investors who want to collect safe and reliable dividends, but don’t need the income from these for regular expenditure today, strongly consider DRIPs as an investment option.
A dividend reinvestment plan (DRIP) is a method through which existing shareholders can reinvest their dividends to purchase additional shares of the company. It is an excellent method to increase the value of investments.
To start off with a dividend reinvestment plan one has to have a set frame of mind and only a few stocks with good quantity after doing due diligence and probably like those forever type of stocks. When you utilize a DRIP, you don’t have to worry about cash flow as you only invest what you get as dividend. And even better, you’re able to grow a greater amount of your investment through compounding, which is quite possibly the most incredible wealth-building secret ever discovered.
At an individual level, it is at the discretion of the investor to select the company that it has conviction in, to reinvest the dividends received from the company it is already holding. This is done as a personal investment decision by the investor to buy additional shares of the company. So instead of taking the cash profits, it is a reinvestment plan of owning additional shares of the dividend received.
Mutual funds also imply this method of reinvestment, where the cash from the dividend received is used to buy more shares with no fee or commission charged. This is the main advantage of a DRIP, low or no fees at all. This is precisely the reason why DRIPs have become a popular mean of investment for a wide variety of investors who can also take advantage of rupee-cost averaging with income in the form of dividends that the company is paying out. By this not only is the investor guaranteed the return of whatever the dividend yield is, but will also earn whatever the stock appreciates to during the time of ownership.
Currently in India, the individual dividend re- investment method through personal choice is a part of the equities and a defined strategy adopted by the mutual funds. However, international markets have a systematic approach of reinvestment of dividends which is worth replicating in our domestic markets as well, with the kind of advantages that it provides.
There are two types of DRIPs, traditional DRIP and synthetic DRIP.
A traditional DRIP is the plan offered by the company, administered by a transfer agent through which one can reinvest dividends to buy additional shares. Some companies also offer discount on the share price. However, only an existing shareholder qualifies for this plan. Because of the difficulties of enrolling in a traditional DRIP, most people only enroll if the company also offers a Share Purchase Plan (SPP). A SPP allows buying additional shares through the transfer agent to add to the DRIP.
A synthetic DRIP is a service offered by the broker. Although it depends on the broker, but most of them do not reinvest in fractional shares. This means that enough dividends are required from one payment to cover the cost of the share.
Example: Say you receive Rs50 as a quarterly dividend payment, but the share price is Rs100. If the DRIP allows fractional shares (A traditional DRIP) then the Rs50 would be reinvested and half (0.50) a share would be added to your account. If the DRIP does not allow fractional shares (A synthetic DRIP) then the Rs50 would not be enough to buy a full share, so it would be deposited as cash in your account.
The biggest advantage of the traditional DRIP with a SPP compared to a synthetic DRIP is that one can buy additional shares often without any commission or fees. Overall DRIPs allow dividend reinvestment in partial shares. Another benefit is that some allow reinvesting dividends by purchasing shares at a discount to the market price. Also one can start with a small amount of money, enough to buy single share of the company.
One of the disadvantages is that to participate in the DRIP you must already have purchased one share of the company. Another problem is that if you want to buy or sell shares at the current market price, you can’t do it. In addition to that, despite the fact most DRIP plans allow low or no fees for purchasing additional shares or reinvesting your dividends, most DRIPs have high initial set-up fees. From a diversification perspective a DRIP investor has to enroll in as many plans as the number of individual companies he or she plans to invest in. This would be an inefficient way to keep track of investments. Also, not all companies offer DRIPs, so you might have to use a broker in the end.
From a long term investment perspective, if you’re not reinvesting your dividends, you’re missing out on one of the easiest and surest ways of increasing your gains. While DRIP may seem like "boring" investments that take a while to pay- off, the long-term benefits of these investments are clear. Using a DRIP today is a low-cost way to build wealth through dividend paying stocks. Let me add a rider to this and that is if you are able match the dividend income from your savings then you are virtually buying the stock at half the price. And when you get to that point in your life when you need a steady stream of income to fund your retirement, you’ll have a big chunk of stock paying a very healthy yield. The bottom line is, whether you’re 20 or 60 years old, or anywhere in between, DRIPs are a sure-fire way to start building your next egg or make up for setbacks your retirement fund may have suffered in recent years.