Dividend Reinvestment Plans:

A Leveraged Investing Alternative

by

Brad Castro

Have you ever been in a long line waiting to get on what’s billed as—and what appears to the naked eye to be—a particularly terrifying roller coaster or amusement park ride? If the ride is especially popular, and the lines are long and slow, you will have ample opportunity to reflect upon the various signs along the way warning that the ride is not recommended for those with heart ailments or other health conditions. You will also come upon the occasional special exit in case you change your mind and feel that this ride is not for you after all.

That’s the purpose this page serves — providing you with a perfectly respectable investing alternative and exit if you ever feel that investing with options (and I do mean investing, as in Leveraged Investing) does not suit you after all. Investing with options is not actually very scary (as opposed to trading options, which is not for the faint of heart). But there may be other perfectly legitimate reasons why options are not right for you. Although options are right for me, if they didn’t exist, or if they were outlawed, the approach outlined here would be my next choice.

[Sidenote: What if you're an options trader at heart and it's Leveraged Investing that's not right for you? Check out the Options Trading Services page for a review of two alternative but legitimate trading approaches that you might find more suitable.]

From my perspective then, the next best long term investment strategy after Leveraged Investing is to consider dividend reinvestment plans. Dividend reinvestment plans, or investing in high quality, dividend paying companies and then using the dividends to purchase additional shares of those dividend paying companies is a powerful illustration of compounding interest at work. Even if the dividend payout never changes, the dividend itself will increase each quarter as you accumulate more and more shares.

[Check out the Reinvesting Dividends page for more detailed information on the benefits of reinvesting dividends.]

If you had to manually administer this process yourself, you would immediately run into two significant obstacles making this approach expensive and inefficient. The first obstacle is the commissions incurred from purchasing additional shares every three months (or, in some cases, monthly). That’s especially so if you lack a sizable position, and the dividend payment only covers the purchase of a few shares at a time.

The second obstacle is how to handle fractional shares? If the stock pays a $0.33 quarterly dividend, you’ve got 500 shares, and the stock is trading for $46/share, your dividend would more or less cover the purchase of an additional 3½ shares. But how do you place an order for half a share?

Fortunately, there are a couple of realistic and advantageous solutions.

DRIPs

The DRIP is administered by the company or a third party with whom they contract. The DRIP handles the complex accounting of partial share purchase as your dividends are reinvested (although, if you prefer, you can usually set things up so that you only reinvest in full shares and receive the balance in cash). An important advantage: there are no commissions involved when the dividends are reinvested.

Further, there are other advantages if you want to invest new money into the account and purchase additional shares on your own. The first advantage is that there is no charge to do so. Just as the reinvested dividend transactions are done commission-free, new investments are handled the same way.

Secondly, in some cases, new share purchases are also offered at discounts to current market price by 1%-10%. This is a huge benefit. It’s like getting an immediate 1%-10% return on your investment.

Drawbacks?

Another thing to consider is that DRIPs really are for long, long term investors. If you’ve got a day-trading or market-timing streak, you’ll want to stay away. Your DRIP account isn’t designed for frequent buying and selling.

[Consider other sound option trading alternatives if you've got an itchy trigger finger.]

Finally, if you are really considering DRIP investing, I urge you to first put together a list of companies you admire and would like to own (see the related site article, "Quality Investing"). Only after that should you investigate to see if any of those companies offer dividend reinvestment plans. Don’t select the stock of an average business just because they offer a DRIP.

That's why I've chosen not to include any links to sites that list companies offering dividend reinvestment plans.

A DRIP Alternative

Most online brokers now offer their own dividend reinvestment plans on the majority of dividend paying stocks. Although not part of any official company-sponsored program, the broker-administered dividend reinvestment palns are also commission-free and can accommodate partial share issues. Details vary from broker to broker, so you’ll need to do your own research and comparisons.

Final Thoughts

I’m very serious. The common denominator between dividend reinvestment and Leveraged Investing is that both are great ways to build long term wealth. The latter approach may be more exciting, but ultimately we invest in order to gain returns, not to be entertained. And don’t let the alleged dullness factor of the former strategy fool you—the tortoise usually gets laid at the end.