Reinvesting dividend payments is a great way to take advantage of compounding and price appreciation. It also eliminates brokerage fees and does not require that the investor have enough money to purchase a full share of stock. When this option is offered by the company that offers the dividends, it is referred to as a dividend reinvestment plan, or DRIP.
Instead of receiving dividends as cash payments, investors enrolled in a DRIP have their dividends directly reinvested in the company. It is important to note that the investor is still required to pay tax on the dividend income when it is reinvested. Some DRIPs charge a fee or commissions for participation, while others are free to participants. The purpose of a DRIP is to encourage long term investment so is usually has a stabilizing effect on the stock price.
Aside from the benefits of increasing holdings and not requiring more than one share of stock to participate, most DRIPs allow additional shares of stock to be purchased for little to no fees. Sometimes, only $10 is required to participate and the stock can be purchased at a discount from market price. Investors can purchase fractional shares of stock, making this a budget-friendly way for them to incrementally increase their holdings.
A DRIP is an effective method to make dollar cost averaging work in the investor’s favor. The investor is not only guaranteed the dividend payment, he or she will receive income based on the stock appreciation price during ownership. However, that situation can also work in the reverse, so there is some risk involved.
Investors who want to build their portfolio with a small amount of money and continue to invest small amounts on a regular basis should explore a DRIP. It allows them to avoid brokerage commissions while reinvesting their dividend payments. It is a steady approach to growing money over the long term.
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