Monday, December 15, 2008

Dividend Reinvestment Plans - Pros And Cons

by Aussie 0 comments

A little while back, in my post about building wealth, I mentioned that I thought it was important to re-invest any income derived from your investment portfolio. It is an example of the compounding effect at work. Today I'd like to share my thoughts on dividend reinvestment plans (sometimes referred to as DRIPs). Dividend re-investment is touted by many a being a great strategy for growing your investments over the long term.

What Is A Dividend Reinvestment Plan?

When a company declares and pays a dividend, investors would normally receive that amount in cash. Under a DRIP, an investor can opt to forgo the cash payment and instead receive the equivalent amount in company stock.

As an example, if you own 100 shares in a given company and that company declares a dividend of $1 per share, you would be entitled to a cash payment of $100. But if that company offered a dividend re-investment plan and you decided to participate in the plan then you could take the $100 in shares. If the company's stock was trading at $50, you would receive 2 shares under the DRIP.

Advantages Of Dividend Reinvestment

Participation in these schemes allows an investor to acquire more stock an a company without paying brokerage fees. This means it can be a low cost way of increasing your ownership of an investment. Even though only a small quantity of stock is accumulated each year, this can add up over a number of years.

To make it more attractive, some companies offer stock in their DRIP's at a discount to the current market price (around a 5% discount or so). This can make the plan an even more cost effective way to add to your holdings.

Disadvantages Of Dividend Reinvestment

The main issue I have with these plans is that you may not necessarily be investing your funds in an investment which represents the best value at any given time. I like the idea of re-investing the income from my stock market investments. It creates a compounding effect whereby the amount reinvested increases the income the following year and so on. But I like to choose where I invest my hard earned cash. I prefer to take all of the income received over a given period then plow it back into the opportunity which represents the best value at that time, or perhaps even invest in a new idea.

Another thing to consider is the additional paperwork required. You will need to track each purchase for tax purposes. As your portfolio starts to grow and the number of holding increases, you will need to track the issue of shares twice or sometimes 4 times per year for each holding.

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