The Power of a Dividend Reinvestment Plan

 A guide to help determine if dividend reinvestment is right for you.

Investors who own dividend-paying stocks face the question of what to do with this cash. You have several options:

1. Have it go into your account as cash, withdrawal, and spend it.

2. Save it. Bank the money to fund future expenses.

3. Invest it. Use your accumulated monthly dividends to buy more shares of something your own, or perhaps, shares of a different company or fund.

4. Reinvest it. Use the dividend to automatically buy more shares of the same company.

Here's a look at this latter strategy to help determine if it's right for you.  

What is dividend reinvestment?

Dividend reinvestment is using the cash dividend paid by a company or fund to buy more shares of that same investment automatically. Any investor can use this strategy since most brokerage accounts have automatic dividend reinvestment programs that automate the purchase of new shares in that same stock, exchange-traded fund (ETF), or mutual fund. Similarly, many dividend-paying companies offer investors the opportunity to participate in a dividend reinvestment plan (also known as a DRIP). Meanwhile, even if a broker or company doesn't provide an automatic dividend reinvestment plan, an investor can manually reinvest their payments.

How does dividend reinvestment work?

Dividend reinvestment is a simple process. When a company pays a dividend, the broker or company uses that cash to buy more shares of the underlying investment, which is completely automated if an investor signs up for automatic dividend reinvestment or a DRIP program. As a result, instead of receiving a cash payment, an investor will get more shares of the company or fund based on the current market rate. If the dividend payment is less than the full share cost, an investor will receive fractional shares. Further, these purchase transactions are usually commission-free.

Here's an example to help investors understand how dividend reinvesting works. An investor owns 100 shares of a company that pays a $1 quarterly dividend. Thus, they would receive $100. However, because this investor signed up for their brokerage account's automatic dividend investment program, it gets reinvested into buying more shares. If shares trade at $25 apiece at the time of this dividend payment, this investor would then own 104 shares.

In the next quarter, this same investor would receive $104 in dividends. If the stock then traded at $26 per share, the investor's reinvested dividends would boost their shareholding up to 108 shares. This wealth-compounding process would continue until the investor sold the stock or turned off the automatic reinvestment program.  

How to reinvest dividends

Investors can usually enroll in an automatic dividend reinvestment program through their brokerage account. With a Fidelity IRA the default is your dividends will buy more shares when it's paid. Starting out, when your monthly dividends are low, this is the route to take. If, and when, Your monthly dividends approach $1,000 per month, you want to change every setting for all your holdings to go to cash. That way you can deploy the cash into specific equities you already own, or into new positions. And with Fidelity, as with most all major brokers, it costs $0 to buy and sell shares.