DRIP stands for “dividend reinvestment plan”, and is the action of buying more shares of a stock that an investor already owns with the dividends the investor has received. It is a fantastic way to earn compound interest, which is the key to long term investing success.
There are many pieces of evidence that DRIP investing can result in serious returns for your portfolio. This blog post will examine 7 of them. Hopefully you will fully appreciate its power and implement with your own investing strategy.
DRIP adds “Double Compounding” to Investors
Though not talked about much, DRIPs add an additional layer of compound interest to a stock investment.
Take the average stock, for example. Buying a stock means buying part ownership of the underlying business. That business earns a profit, then uses some of that profit to reinvest in the business. They do that by buying assets. This unlocks the ability to earn even greater amounts of profits in the future, which enable higher reinvestment. Like a snowball, the effect compounds.
Businesses don’t only use profits to reinvest in the business for future growth. They also pay some of their excess cash back to shareholders, in the form of dividends or share buybacks. This allows the shareholder to experience a compound effect in addition the one from profits.
Just like the business reinvests for higher future profits, investors can reinvest into the stocks they already own for higher future gains.
The longer an investor “DRIPs”, the more shares that an investor accumulates over time. As the investor’s overall share count increases, more and more shares are able to be purchased for additional reinvestment– creating an explosive compounding effect.
Combine the two compounding forces and you have a sort of “double compounding”. Having more overall shares means an investor gets a higher return from a compounding/ increasing stock price than one if he never reinvested.
2. Dividend Growth Adds 3rd Power Compounding
There is a third part of all of this compounding talk that is unique to DRIP situations.
When a stock grows their dividend in addition to growing their earnings, the DRIP effect multiplies again.
Remember that each subsequent year of reinvestment means higher and higher levels of reinvestment. The dividend an investor receives in year 1 is going to be less if he only has 100 shares compared to a dividend in year 2 where he might have 103 shares.
The higher potential levels of reinvestment accelerate even faster if the stock dividend is growing. Say a stock pays a $2 dividend, then increases their dividend to $2.20 the very next year.
Well as a dividend investor, you don’t have to do anything to receive dividends. As long as you hold the stock, you’ll get paid a dividend.
What that means is that if the company continues to grow their dividend year after year after year, you’ll continue to get higher and higher levels of dividend payments every single year.
Again, that means higher and higher levels of reinvestment potential. So the investor sees compounding in the share price, in the actual dividend payment, and from the accumulation of additional shares through his DRIP plan.
Sounds great to me.
The massive potential of dividends and a “back to the basics” explanation of dividend paying stocks is covered in depth here:
3. DRIP = Major Portion of S&P 500 Returns
I got the cold, hard facts for this point after being prompted by a great question from a subscriber to The Sather Research eLetter.
Daniel: I think I understand the DRIP concept and how it compounds. Your holding slowly grows with each dividend and each dividend slowly grows based on your holding. But I did not think this would be a serious part of the expected 11% of the total, at least not yet. Am I wrong about that?
Most people don’t know actual contribution that reinvested dividends have towards overall investment returns, hence the poor public misconceptions that dividends are for old people.
There’s a great S&P 500 return calculator on dqydj.com. I ran a scenario investing in the S&P 500 for 40 years– from May 1978 to May 2018. Returns were as follows:
- Without dividend reinvestment: 8.6% CAGR
- With dividend reinvestment: 11.6% CAGR
That extra 3% is 25% of that 11.6% annualized return, which is a serious component of the overall performance. [click to continue…]