How Reinvesting Dividends Builds Wealth

The case for reinvesting dividends as you build your portfolio.

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Miranda Marquit

If you are interested in building wealth at a slightly faster pace, one strategy to try might be using a dividend reinvestment plan (DRIP).

Investing in Dividend Stocks

Dividend stocks are gaining in popularity due, in part, to the fact that they keep paying out, even when the market drops. While it’s possible for companies to cut—or even eliminate—dividend payouts as they wish, many dividend paying companies don’t do this unless they are facing some sort of fundamental problem.

When you invest in a dividend paying stock (or a dividend paying fund), you receive a portion of the profits earned. Your portion depends on how many shares of the stock you own. So, if a company pays a 50 cents per share dividend, and you have 100 shares, you end up with $50. This payout is in addition to any capital appreciation you might be seeing.

While you can use a carefully constructed dividend portfolio for regular income, it can really be worth your time to make use of a DRIP if you are in the “building” phase of your portfolio.

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What is a DRIP?

A dividend reinvestment plan automatically takes the dividends you earn and reinvests them in the stock. Continuing with the example above, if the stock is trading at $100 a share, that $50 is automatically reinvested to buy you half a share. If you have a quarterly payout, you end up with approximately half a share extra each quarter (assuming the price is relatively stable). After a year, you have two extra shares.

Now, you have 102 shares of the stock, and you didn't have to invest extra money; your dividend payouts were just reinvested automatically. Now, your dividend payout each quarter is $51.

Some DRIPs will allow you to buy quarter shares, as well as half shares, and this can speed up the process a little bit, since you don’t have as much money sitting idle, waiting to build up enough to purchase another partial share.

Improve Your DRIP

It seems like slow going at first, since the improvements are made in increments. And in the above example, there isn't a purchase of new shares. Where a DRIP can really shine is if you combine it with dollar-cost averaging. Consistent investment over time, combined with automatic investment can provide increasingly dramatic results.

You invest $200 a month in our stock that is selling at $100 a share. Each quarter (every three months) you add six shares. So, starting with your 102 shares of stock at the beginning of the year, you add 24 shares from your dollar-cost averaging plan, and two more shares from your DRIP. Now your payout is up to $64 a quarter, and you’re still reinvesting the dividends.

In the meantime, your dividend might rise (dividend aristocrats increase their payouts each year), increasing the payout per share. If the stock price drips, you can buy more shares with your reinvestment.

Of course, the flip side is that the company could decide to cut the dividend, or the stock price could rise, reducing the number of shares you can buy through your dollar-cost averaging strategy and your DRIP. This can slow you down a little bit.

Overall, though, a DRIP strategy can be helpful for boosting your investment portfolio and helping you build wealth over time. Like other long-term investment strategies, this one requires attention to the fundamentals of the investments you choose as well as patience; you need to recognize that this strategy can take 10 years or more before you start seeing significant income from your portfolio.

But if you stick it out, and have realistic expectations, this strategy might work for you.

Miranda is a freelance contributor to several investing and personal finance web sites. She also writes for her own blog, Planting Money Seeds.