How to Invest with DRIPs and Boost Your Returns

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It's a strategy that isn't discussed often in the financial media, and on top of that, it has an odd name. So if you're wondering why you need to know how to invest with DRIPs, just wait until you learn how powerful they can be.

DRIPs are Dividend Reinvestment Plans - at its most basic, a simple, easy way for long-term investors to reinvest money into a company they already own.

Dividends by themselves are a great thing.

A number of studies over the years have shown that dividends accounted for more than 60% of total U.S. stock market returns since the 1870s.

But guess what happens when you reinvest those dividends?

The book Triumph of the Optimists: 101 Years of Global Investment Returns foundthat, in the 20th century, a portfolio with dividends reinvested returned about 85 times the wealth of a similar portfolio that relied solely on capital gains.

Clearly, anyone interested in accumulating wealth over the long term needs to take a very close look at investing in DRIPs.

DRIP Investing: What Are Dividend Reinvestment Plans?

Dividend reinvestment plans, or DRIPs, are special programs sponsored by corporations that allow shareholders to immediately reinvest their regular dividend payouts back into the company's common stock.

And many DRIPs have been set up by companies known as "dividend aristocrats." Such companies have increased their dividend payouts every year for decades.

Blue-chip companies such as the Coca-Cola Co. (NYSE: KO) and General Electric Co. (NYSE: GE) come to mind as prime examples of dividend aristocrats.

But while those companies are ideal for DRIPs, well over 1,100 companies offer a dividend reinvestment plan.

Companies do this because it benefits them in two major ways.

First, it is an ultra-cheap source of additional capital for the firm. And second, investors that participate in DRIPs offer companies a very stable shareholder base. Such investors are much less likely to panic and sell out at the first hint of trouble in the stock market.

The Benefits of DRIP Investing

But retail investors derive even more benefits from DRIPs...

  • DRIPs allow investors to reinvest almost any amount they wish via the plan, usually on a quarterly basis. Many companies allow investments as small as $10 and allow for the purchase of fractional shares, so the small investor is not left behind. Large investors also enjoy flexibility, as purchases as high as $500,000 can be made.
  • The fees are zero. That's because there are no brokers involved. The company sells you the stock directly from its own share reserve.
  • In many cases the stock is purchased at a 3% to 5% discount to the current market price. Some DRIPs also offer the option to make cash purchases of additional shares at the same time the dividend is reinvested - at the same discounted price and with no broker fees.
  • But perhaps the biggest benefit of using DRIPs is dollar cost averaging. Dollar cost averaging simply means you buy a fixed amount of a stock on a regular schedule, regardless of the price. (This is also how most 401(k) plans work.) So when the stock price is higher, you buy less; when it's lower, you buy more. Dollar cost averaging negates the perils of trying to time the market and results in better returns over the long haul.

How to Invest with DRIPs

Getting a DRIP account started requires a little homework by the investor. First, you need to research which companies offer DRIPs.

One of the easiest ways to find out if a company offers a DRIP is to go to its website and look for the "Investor Relations" link (you might have to hunt; companies often bury such links at the bottom of their web page). Or you can just call the company's Investor Relations department.

Keep in mind that to participate in a DRIP, one must first be a shareholder in the company. However, some firms do allow investors to buy their initial share of stock directly from the company as well.

Even if a company does not offer a DRIP, there are alternatives that offer the same advantages. Some brokerages and DRIP advisory firms have created synthetic DRIPs for many of the more popular stocks that don't offer the real thing.

Some of the DRIP service companies include: Direct Investing, DRIP Advice, and DRIP Wizard.

Some brokerages that make it easy to make DRIP-style investments in stocks for very little cost include ShareBuilder and Folio Investing.

Drawbacks to DRIP Investing

There are two minor drawbacks to investing with DRIPs.

The first is that you will still be taxed as if you received the dividends in cash.

The second is record keeping. You will have to keep track of every purchase (price and amount of shares) so that when you sell the shares, you can accurately report your cost basis to the IRS.

Software, such as that offered by DRIP Wizard and others, can make the record keeping easy. Or, if you have an account at a brokerage firm, it will do the record keeping for you.

Now bear in mind that using DRIPs will not instantly turn you into Warren Buffett. But it will allow you to accumulate wealth in the same steady, patient way that he has. And that's no small thing.

Editor's Note: DRIPs are a wonderful tool, but if you're seeking income, you also can't afford to overlook a form of investing that delivers excellent yields. The most promising opportunities happen to be in the housing recovery and healthcare...

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