You can DRIP along to a nice portfolio

It's a painless way to reinvest dividends, despite some drawbacks

Dollars & Sense

March 30, 2003|By David Kathman | David Kathman,MORNINGSTAR.COM

Do you feel it's better to reinvest dividends in their original payout company or let the dividends compile, later investing them in a stock of your choosing?

That depends on a lot of factors, including the company paying the dividends and your own financial goals. But with dividends increasingly in favor these days, it's good to be thinking about such things. Dividends have plenty of attractions, but if you want to reinvest them in the company that paid them, there are some things you should know.

Once upon a time, dividends were the main reason people owned stocks, and a stock's yield was one of the first things investors wanted to know about it. Over the past few decades, though, dividends have become less important.

One disadvantage of dividends from a shareholder's perspective is that you have to pay taxes on them. That could change if the Bush administration's new tax proposal goes through, but that's far from a sure thing. Even if you invest those dividends right back into the company and never see a penny of cash, the IRS still considers them taxable income. That's one reason why dividend yields have been falling over the past couple of decades, and share buybacks have become more popular.

However, the prolonged bear market of the past three years has made dividends look a lot more attractive. Not only do they provide a cushion against a falling stock price - or an extra boost when the stock's price is rising - but there's quite a bit of evidence that companies paying dividends tend to perform better than those that don't.

A new academic study has found that earnings grow faster when companies pay out a greater percentage of earnings as dividends, rather than investing that money back in the company. And as Morningstar editor in chief Haywood Kelly has also noted recently, stocks with steadily increasing dividends have performed significantly better over the past five years than has the market as a whole.

But if you own stocks that pay hefty dividends, what should you do with those dividend payments? One option is to spend them on living expenses or other things. Most investors close to retirement (or in retirement) are looking for income, and dividend-paying stocks - along with bonds - are one way to achieve that goal. High-yielding stocks such as utilities were traditionally known as "widows and orphans" stocks because of their low risk and steady dividend payments.

If you've got a longer time horizon, it's usually a good idea to invest your dividends in order to maximize your total return. That's where the question comes in: Is it a better idea to reinvest those dividends back into the original company, or save them up and put them into some other investment, such as a different stock?

The second option is one potential way to diversify your holdings, but it comes with a number of pitfalls. Primary among these is the fact that dividends are usually issued in quarterly increments; if you invest each of those payments separately in the same stock, the brokerage fees can really add up.

If you want to reinvest those dividends in the original stock, dividend reinvestment plans, or DRIPs, are a good way to go. DRIPs are run by the companies themselves, and they have a number of advantages that can make the whole process easier. For one thing, DRIPs are usually less expensive than going through a broker; while there's often a fee to enroll, your dividends are then automatically reinvested with no transaction fees. DRIPs also allow you to buy fractional shares, so you don't have to worry about any of the money being left over and lying idle. Most of them don't require big initial investments, and many allow you to make additional cash purchases on top of the reinvested dividends.

There are some drawbacks to investing through DRIPs, however. It's usually possible to buy and sell shares only on a specific date each month, and orders have to be placed ahead of time, giving you little control over the purchase or sale price. Keeping track of your cost basis and taxable dividends received is a real pain, but financial software such as Quicken can help. Record-keeping can also become a hassle if you invest in DRIPs at several different companies. However, some discount brokers, such as E*Trade, make it easy to consolidate your DRIP portfolio in one place, and they will even automatically reinvest dividends for stocks that don't have their own DRIP.

DRIPs aren't for short-term traders; they're intended for disciplined, long-term investors who want to gradually build up their portfolios. To find companies that offer DRIPs, you can use Morningstar's Premium Stock Screener, or you can find an alphabetical list of plans on Netstockdirect.com.

To find out more, check out "How to Invest with DRIPs" on Morningstar.com, as well as the DRIP Central Web site. These resources should give all you the information you need to start investing in DRIPs.

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