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DRIP Investing: Manage Risk with Dividend ReInvestments

By  +Follow January 13, 2014 9:00AM
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In an episode in the fourth season of Seinfeld, George reveals to Jerry that a savings plan he had briefly contributed to in Middle School with installments of less than $1 has gathered enough interest to reach a value of $1,900.

Of course, George ends up blowing the money buying art from a man he believes to be terminally ill only to watch him make a full recovery and ruin George's hopes of the artwork spiking in value after his death, but the basic idea speaks to the hopes and dreams of most small-time investors.

While some retail investors may take a very active and aggressive approach to managing their investments, many people are too busy with jobs and family life to spend hours researching stocks. The idea of a simple plan that, with relatively minor initial contributions, will mature over time into a healthy nest egg without needing active management is precisely what many investors are chasing.

As such, one method for creating the sort of exponential growth that can turn loose change into $1,900 is known as DRIP investing. It's a relatively simple strategy that involves investing in a corporation and then reinvesting the cash dividends that company pays to shareholders. By reinvesting dividends, investors can boost returns and begin to see the sort of compounding growth over time that can help a relatively small initial investment grow into a real nest egg provided that the company in question remains stable. Like any investment, DRIP investments are no guarantee, but they can be a relatively low-risk method to invest for the future.

Basics of DRIP Investing

The benefits of a DRIP plan come from the win-win nature of the investment. Companies typically find DRIP investments attractive because they create a relatively stable, loyal base of shareholders. Investors like DRIP plans because they offer an opportunity to avoid broker commission fees and can be made in much smaller quantities than other traditional investments.

DRIPs are typically done through the company itself, but some companies will use a third party to handle DRIP plans. All DRIPs work by using cash dividends to purchase new shares or fractions of a share in the company, reinvesting dividend returns directly into more stock. This allows an investor to increase the value of an investment over time.

What's more, because more shares mean more dividends, the growth of the value of the investment should be exponential (independent of the company's share price, which can obviously vary widely). The longer one holds the investment, the greater the dividend received each quarter will be, which increases the size of the holding, which increases the dividend, which increases the holding, etc.

There are two basic types: Market DRIPs and Treasury DRIPs. Market DRIPs use the open market to purchase new shares, while treasury DRIPs involve  buying shares directly from the company treasury. In a treasury DRIP, the company gets to take the money from share purchases, which means that said companies are often willing to offer discounts on new shares that typically fall between 2 and 4 percent. In both cases, DRIPs are a relatively safe investment that can grow a great deal if left alone over time and don't require a lot of upkeep on the part of

Which Companies to Invest in?

Not all companies offer a DRIP program, so one must find those that do. After that, one must consider that a DRIP investment involves tying those funds to the fortunes of an individual company, a strategy that inherently carries some risk (substantial risk when compared to an ETF or mutual fund). If the company your DRIP is in has its share price crash and never recover, the value of the investment is going to crash with it. Unforeseen changes in a company's dividend plan can also hurt the value of a DRIP.

What's more, a DRIP investment only really makes sense if one intends to hold it for the long term. Investors entering into a DRIP should expect to leave the money they put in untouched for years or even decades. As such, investing in stable companies with fairly predictable long-term outlooks probably makes the most sense.

Also, a strong dividend is very beneficial. The bigger the dividend yield, the better the quarterly growth of the DRIP will be.

Many Options for DRIP Investors

There is a wide range of companies offering DRIP programs, over 700 according to dripinvestor.com, so choosing one could (and most likely should) involve some research. However, after doing due dilligence and researching different potential investments, DRIP investing can be a great way for an investor seeking out simple, no-hassle investment opportunities.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.


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By  +Follow January 13, 2014 9:00AM
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