What are the Benefits of a Dividend Reinvestment Plan (DRIP)?
Record volatility has made 2020 one of the most difficult investment climates in recent memory. A public health crisis, economic distress and geopolitical tensions have forced many investors to reevaluate their risk tolerance and investment goals. Despite these challenges, tools like the dividend reinvestment plan, or DRIP, can help you stay on track.
The dividend reinvestment plan gives shareholders the opportunity to put their dividend dollars to work. Rather than redeem your dividend payment, a DRIP program allows you to reinvest that capital into additional shares or fractional shares of the underlying asset or fund. By reinvesting the cash, you can acquire more shares without having to pay commission or broker fees. If employed frequently enough, a DRIP becomes a form of dollar-cost averaging that allows you to acquire additional shares at a lower cost.
Most dividend-paying securities are eligible for a DRIP. As long as the security or fund is DRIP-eligible, shareholders can participate in the program.
Here are four major advantages of employing a DRIP strategy in your portfolio.
When you exercise a dividend reinvestment plan, you can buy additional shares at a lower cost than outside investors. Company- and fund-operated DRIPs are commission-free because no broker or third-party is needed to facilitate the sale. Reinvesting dividends can also be done automatically, which saves both time and money.
The inherent cost savings associated with DRIPs are advantageous to small investors who normally cannot afford to pay trading fees. As an affordable investment option, DRIPs are a viable strategy for new investors.
Legendary value investor Warren Buffett once said, be “fearful when others are greedy, and greedy when others are fearful.”
A DRIP strategy allows you to keep investing and reinvesting when the market is fearful. This system of dollar-cost averaging—investing in assets at regular intervals regardless of the price—is one of the most reliable risk management strategies ever conceived.
Dollar-cost averaging through a DRIP reduces your overall investment risk and protects your portfolio against major market downturns. It also gives you the ability to ‘buy low’ because you are contributing pre-defined amounts each period (month, quarter, etc.) regardless of the business cycle.
Risk management isn’t the most exciting aspect of investing, but it’s essential for long-term growth.
When you employ a DRIP strategy, you get to decide how much of your dividends you want to invest. It’s not an all-or-nothing proposition. You can choose to invest only a portion of your dividend and pocket the rest as cash. That means you can buy fractional shares, something most brokers won’t let you do.
The dividend portions you can reinvest vary, so it’s best to verify with the firm’s prospectus.
Reinvesting dividends encourages investors to keep their shares for longer and to accumulate more over time. A DRIP is an excellent way to invest for the future because it enables dollar-cost averaging while saving you commission and other fees. You can think of dividend reinvestment as a long-term buy-and-hold strategy that can be employed automatically and with little effort.
The DRIP strategy enables you to generate compound returns, which gives you a greater share of the security or investment vehicle the longer you invest. This setup is suitable for retirement planners seeking stable, long-term growth.
When a DRIP Doesn’t Make Sense
For all its benefits, a DRIP strategy is not suitable in all situations. If you decide that your dividend distributions are better utilized as cash, you may opt-out of a DRIP and use the extra money to invest in other securities. This strategy is effective for investors who want to use their dividend distributions in a TFSA or other tax-advantaged accounts.
If you invest in dividend-paying securities to generate regular income, a DRIP may not be in your best interest. Additionally, some of your dividend payments may need to be redeemed to cover taxes (more on that below).
Don’t Forget About Taxes
When deciding whether a DRIP is right for you, it’s important to consider the tax implications. If your securities are held in a taxable account, dividend payments are taxed regardless of whether they are reinvested or not. In other words, a DRIP doesn’t protect you from paying taxes if the investment is held in a taxable account.
To avoid a tax liability, investors can opt to purchase shares in a tax-sheltered account like a TFSA. These accounts have contribution limits.
The Bottom Line
Reinvesting your dividends could be your ticket to compound returns without having to wait for cash to accumulate in your portfolio. Through dollar-cost averaging, a DRIP simplifies the investment process while saving you money.
While DRIP investing is safe, it may be important to rebalance your portfolio over time so that you don’t end up over-exposed to one security or asset class. Employing other risk management principles, such as diversification, can help you avoid concentration risk.
CMI’s Mortgage Investment Corporation rewards shareholders with monthly dividend payments that can be reinvested into the fund. Learn more about how mortgage investing works.
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