DRIP investing helps you save on commissions and reinvest your dividends in more shares.

Dividend reinvestment plans, or DRIPs, are plans some companies offer to allow shareholders to receive additional shares in lieu of cash dividends. DRIPs bypass brokers, so shareholders save on commissions.

DRIP investing also eliminates the nuisance effect of receiving small cash dividend payments. Second, some DRIPs let you reinvest your dividends in additional shares at a 5% discount to current prices. Third, many DRIPs also allow optional commission-free share purchases on a monthly or quarterly basis.

How to participate in DRIP Investing

To participate in a DRIP, you must first own and register one or more shares of a company’s stock. Share registration (through a traditional or discount broker) will generally cost between $40 and $50 per company. Then you must contact the company to ask for the form you fill out to enroll in the plan.

Overall, we think drip investing is a good way to build wealth over a long period of time. But here are a few things to keep in mind:

A DRIP is not a sign of investment quality: We think DRIP investing is okay to participate in if you use them to cut commission costs on stocks you would have bought anyway. But confining your investments to stocks that offer DRIPs is a terrible idea. That’s because not all stocks that offer DRIPs are good investments. And you can lose a lot more on these stocks than you could ever save on commissions.

DRIP investing has lost some of its cost-saving advantages: DRIPs offer much less of an advantage now than they did in, say, the 1980s, when brokers charged 2% or more to buy stocks. Now, thanks to the growth of discount brokerage and Internet competition, you can buy stocks for a commission cost of 0.5% or less. In addition, many companies that offer DRIPs have done away with the 5% discounts that used to be common. Now you pay full price to buy through most DRIPs.

Careful record keeping is still necessary with DRIPs: You’ll need to keep careful records of all purchases to compute your capital gains and losses when you sell. Many investors find this particularly troublesome, especially when they inherit the task. As well, keep in mind that you must still pay taxes on dividends that you reinvest.

Overall, we think that DRIP investing is okay to participate in for most investors. To review:

• Many investors make their investment choices solely on the basis of the existence of the DRIP option. We think the availability of a DRIP is only a bonus, rather than a reason to invest by itself. Investing only in stocks that offer DRIPs limits both investment choice and opportunity.
• The advent of the low-cost discount brokerage and online investing has reduced the commission cost of investment trades. Thus, the commission-free investing that DRIP investing allows is less of an advantage today than it was in the past.
• Taxes are still payable on dividends that are reinvested in the year they are received.

Most companies that offer DRIPs provide details on their web sites. Another place to look for information is the inside back cover of most companies’ annual reports. You can also contact the investor relations department of companies you wish to invest in.

Don’t know where to start with DRIP investing? You should look at our dividend stock recommendations. Here are few indicators of dividend quality we look for:

• High-quality dividend paying stocks should have a history of paying a dividend. One of the best ways of picking a quality dividend stock is to look for companies that have been paying dividends for at least 5 to 10 years. Companies can trump up quarterly earnings, issue press releases to appear to be making strong progress, but they cannot fake dividends. Dividends are cash outlays that an unsuccessful company could never produce. A history of dividend payments is one thing that all the best dividend stocks have in common, and one you’ll want to seek out if you’re interested in DRIP investing.
• The best dividend stocks dominate their markets. We look for Canadian dividend stocks that have industry prominence, if not dominance. Our reasoning, besides brand recognition, is that major companies can influence legislation, industry trends, etc. to suit themselves. Minor firms can’t do that.
• Dividend stocks with very high dividend yields should be examined very closely. While they seem enticing for DRIP investing, they are often indicative of a stock that may soon cut its dividend rate.

What have your experiences been like with DRIP investing? Has it been profitable for you? Share your experience with us in the comments.