Dividend Reinvestment plans (often referred to as “DRIPs”) are arrangements that one makes with a participating company to receive more shares (perhaps fractional shares) in lieu of a cash payment for dividends.
These plans have been around for a long time (decades…) and date back to a time when buying stock was a lot more complicated and expensive than it is today. Commissions on stock purchases used to be very high when it came to small investments, and the trading of amounts less than 100 shares was a pain. DRIPs provided a way to handle both of these at once, since the transaction was directly with the company (i.e. no broker and no market-maker involved).
With the advent of online brokerages, both of those concerns have essentially gone away. Brokerage fees are now pretty negligible (unless you just insist on continuing to pay an old-style broker), and trading small numbers of shares is easy. DRIPs had value because they solved a couple of problems. The problems really no longer exist, and some have called into question just how much value DRIPs still retain.
Still, if your goal is to efficiently redeploy dividends as soon as they come in, and you feel that additional exposure to a given stock is a good fit for your portfolio, DRIPs are an easy way to facilitate it. Many investors have built large holdings in this way over the course of many years, and there is at least some evidence to suggest that companies which make a big deal out of paying dividends are well-run and do better than some of the flash-in-the-pan darlings which often capture the attention of the market for short spurts.
The downside of DRIPs includes both record-keeping and risk exposure concerns.
On the records front, every fractional purchase has to be recorded at its own acquisition price so that the proper basis number is available when shares are sold. Otherwise, it becomes difficult or even impossible to calculate the proper tax amount. Tracking these small transactions is easy to do on a spreadsheet, provided you are diligent about it every quarter and otherwise keep good records. If you don’t, having to do several years’ worth of catch-up while in the midst of trying to prepare a return and meet a filing deadline, could be a nightmare.
The more substantive concern though is the risk issue. Owning individual stocks exposes capital to specific cases of implosion in a way which is essentially eliminated by the ownership of funds or ETFs. There are no examples of an entire industry going down for the count and ceasing to exist. But there are countless examples of individual companies doing so. So where as a sector or market should theoretically always have some sort of value, the stock of a company can – and does – go to zero.
The ownership of the individual stock in the first place constitutes a risk factor. The longer you hold it and the more capital you put into it only intensifies the situation. When dividends are directly reinvested in the stock from which they came (versus being reallocated to another stock, or a different asset class entirely), then the risk of losing initial principal becomes a risk of losing the original principal and everything it has ever gained since acquisition. There is no way to reinvest the dividend and diversify the risk at the same time. So the longer the holding has been in place, the higher the dividends paid, and the greater the appreciation in price – you know, all the things you want to have happen when you buy a stock – the greater the risk: because the thing you have to lose by that point is a whole lot bigger than what you originally stood to lose.
Compare this situation to say, a bond investment. The bond may ultimately default, causing you to lose everything you invested at the beginning. But that loss will be at least partially offset by all the interest you received; whether it was reinvested elsewhere or just used to buy golf balls. The yield was not put at risk by leaving the capital at risk. But the effect of a DRIP is to remove the separation from the asset and its produce; making all of it subject to loss in a doomsday scenario.
Finally, on the tax front, the dividends are still taxable even if you don’t receive them in cash. So provisions will have to be made to pay these taxes from another source.
A DRIP held in an IRA will take care of the bookkeeping problem mentioned earlier (since the only number which matters tax wise is the eventual distribution), and the funding question for dividend related taxes. So that’s a plus. Unfortunately, the IRA can’t do anything about the fundamental risk exposure issue, and its ever-increasing nature. That’s a hard-wired part of DRIPs that can only be avoided by purposefully trimming the holding periodically (which is counter to the purpose of the DRIP in the first place) or staying away from DRIPs entirely.