Last week I wrote about why tracking your net worth is so important. It’s not just important, it’s actually vital so that you’re able to see your progress. One great way for new savers to build wealth is by setting up a DRIP.
What is a DRIP?
In the investment world a DRIP is an acronym for a Dividend Reinvestment Plan. This is the process of owning shares in a company that pay out a dividend, but instead of taking the dividend as cash, the investor uses that amount to purchase more shares of the company. This increases the amount of stock they hold and thus increases any future dividend payments that they would receive. The process is done by setting up automated payments once a month (or quarter) to purchase the shares in a selected company. This is perfect for the average investor as it allows them to use dollar cost averaging. Dollar cost averaging removes the emotional aspect of trying to time the market and lets the investor average the price of their purchase over time since they’re slowly purchasing the stock. DRIPs are also extremely useful for someone who is looking to invest but doesn’t have a lot of money to begin with. I have seen DRIPs where investors deposit as little as $10 a month into their plan. It may not sound like much to begin investing but with enough time it will surely build wealth.
Think of a roof that has a very small, slow leak. You would place a bucket beneath the drip to catch the water coming through. If you were to sit there and watch that bucket collect water it would seem as if there’s no way it could ever fill up, almost as if evaporation will occur at a quicker rate than the bucket is filling. So you leave and try to figure out what you need to do to repair the roof. In the meantime that bucket is slowly filling with water. Drip by drip its level goes up. Upon your return you find that the bucket is nearly full.
Now consider this. What if that leaky roof over time gets progressively worse? Perhaps after a couple of days it increases in size by the tiniest of fractions. And a few days later it increases by another very small fraction. Now, instead of one small bucket you need a larger bucket to collect the water dripping through. Eventually that larger bucket will fill up and you’ll need to find an even bigger bucket. As you can see, leaky roofs are no joke, but more importantly this demonstrates how investing in a DRIP works. You start off very small. So small in fact that you barely notice any change. Your first dividend reinvested will be quite small, maybe even a fraction of a dollar. Over time, however, these dividends increase in size dramatically. The dividends will typically increase due to 3 causes, consistently adding a monthly contribution, dividends reinvested now receive dividends, and companies try to increase dividends when feasible if they believe they can sustain that payout going forward. Even during recessions many companies have either held their dividends constant or continued to increase their payout. Cutting a dividend is a signal to shareholders that the company can’t afford to payout its cash like it used to, which prompts a decrease in the company’s stock price. As you probably guessed, this is not something the company wishes to do so it will do anything it can to continue making that dividend payment.
What to Look for in a DRIP
When creating a DRIP try to look for companies whose names you recognize and whose dividends have either held constant or increased in recent years. It’s important to use DRIPs for companies which you believe will operate as a going concern (i.e. far into the future) since you will be continually investing in them. Check to make sure that there are no ongoing fees or transaction costs when depositing your amounts as this will eat into your returns. Transaction costs can vary by company, even if you’re using a DRIP from the same website. Personally I have picked a few solid companies that I believe in and have begun an automatic withdrawal once a month with the minimum required. You can always increase your contributions later on.
Advantages and Disadvantages of a DRIP
Invest very small amounts of money
Uses dollar cost averaging
Doesn’t require the person to take an active investing approach
Can be linked to automated payments
Builds wealth gradually
Many large, stable companies offer DRIPs
Can be setup within a Roth IRA
Some paperwork may be required to start/stop a DRIP
Due to many purchases calculating your cost basis is time consuming
No get rich quick scheme here (actually a pro of DRIP investing)
No broker to give you advice
As you can see using a DRIP may not be appropriate for everyone. If you’re looking to get rich quick or feel the urge to trade often in your account then DRIPs probably aren’t for you. If you’re looking to slowly build your wealth over time and use many small investments to snowball into large balances then DRIPs may be a great option. Personally I have found DRIPs extremely beneficial and a great method for slowly increasing my net worth. My only regret is not starting sooner. I really enjoy seeing a new dividend being paid out and then looking at what the amount was when I started. For example the first dividend I received was for a whopping 37 cents three years ago. Just last month the dividend was $20.08. Still not a huge amount but it is nice seeing that grow every quarter. All of this coming from a small automated payment each month that I barely even notice. Take a look at the graph below to see how the dividends in my Ford DRIP have increased over time.
How to Setup a DRIP
I currently use DRIPs to purchase stock in Union Pacific, Ford, and Phillips 66. If you are interested in a DRIP check on the company’s website to see if they offer one directly. Many companies offer this plan directly. If not there are several websites that will act as a transfer agent and setup a DRIP. I use www-us.computershare.com and have found it easy to use. I choose plans that have no account opening fees as well as plans that offer no or very low transaction costs. You will need to verify certain information before the plan is enabled, such as your birthday and social security number.
Anyone reading this have anything to share regarding DRIPs or wonder if a company you like offers the plan? For people that have been using them for quite some time now have you noticed that your bucket is progressively getting bigger?