A solid, well balanced and diversified portfolio includes a mix of stocks, dividend stocks  bonds, mutual funds and other investments. Many investors, particularly older retired folk, prefer to invest a greater chunk of their portfolio in dividend and fixed income securities that give them a steady income stream to supplement their retirement earnings. Many other investors prefer, instead, to have their dividends automatically reinvested back into their favorite dividend-paying stocks through what are called Dividend Reinvestment Plans (DRIPS).

DRIP: A dividend reinvestment plan (DRIP) allows shareholders to automatically have their dividends reinvested in the specific stock that pays them the dividend. For example, if you hold shares of CSX Corporation (NYSE: CSX) – one of America’s leading rail freight companies – you could have your CSX dividends redirected straight back into CSX shares once you enroll in their DRIP plan with a minimum investment of $500.

With DRIP investing, you forgo the cash dividend payment option. DRIP investing is deferred gratification rolled in with the benefits of compounding for solid long-term gains. DRIPs are typically offered by public companies through their appointed agents (specialists in managing and administering DRIP investment plans for multiple public companies) or through brokers such as TD Ameritrade.

DRIPs are typically offered to encourage long-term ownership of company shares and often have the added benefit of zero reinvestment costs, typically with a nominal one-time account setup fee ($10 with CSX) and a small commission (another $10 with CSX) when you decide to sell shares you hold in your DRIP plan.

However, not all companies offer free or low setup and exit fees. Given the competitive landscape, many brokers often charge less than company appointed agents for DRIP plans. Make sure you check all fees before selecting your plan administrator.

DRIP Example: Consider the following simplified example based on actual dividends paid by CSX and actual CSX share price performance over a nine year period from January 1, 2003 through January 1, 2012.

Say two investors, Jack and Jill, each bought 100 shares of CSX stock on January 1, 2003 at $4.72 per share (actual historical price). Jack chose to collect his dividends as cash. Jill, on the other hand, chose to have her dividends reinvested back into CSX stock. Back then, CSX had an annual dividend of $0.40 and a healthy 8.5% dividend yield.

Nine years later, on January 1, 2012, CSX shares were at $21.06. Jack’s 100 shares were worth $2,106 and he collected $572 in dividends for a total of $2,678. Jill, on the other hand, now owned almost 159 shares with a market value of almost $3,350, fully 25% more than Jack.

The graph below shows the market values of their respective portfolios over the past nine years.

Clearly, Jill has come out significantly ahead by leveraging the power of DRIP investing.

DRIP Mechanics: For Jill, with a DRIP, the dividend per share was multiplied by the number of shares she owned (100) to arrive at her total dividend payout ($ amount). This $ amount was then used to buy CSX shares at the closing price on the date dividends were paid. The additional shares bought were then added to Jill’s account thereby increasing her portfolio to slightly more than 100 shares. The next quarter, Jill received dividends on her new (higher) number of shares, which were again reconverted into CSX shares, further adding to Jill’s holdings, and this process went on quarter after quarter, automatically, without Jill having to worry about receiving dividends, buying more shares and paying trading commissions.

Fractional Shares: In 2003, CSX paid 10 cents in dividends per quarter so Jill received $1 as dividends for her 100 shares. This $1 was used to buy a fractional amount of CSX shares.

With a DRIP, Jill can buy fractional shares without paying trading commissions.

Here’s how: Typically, with DRIPs, each individual DRIP investor does not have enough money to buy even a single share so the DRIP administrator pools dividends with other DRIP investors and uses the total to buy shares, then allocates fractional shares based on each investor’s dividend contribution.

Without a DRIP, Jill would not be able to buy fractional shares, she’d have to pool her dividends till they added up and then buy whole shares. Moreover, she’d incur trading commissions that would significantly add to her costs, making this exercise futile without a DRIP plan.

Higher Yielding Shares Perform Better: DRIPS typically work well with companies that consistently pay dividends, consistently increase dividends over time and offer with a decent dividend yield (2.5% or higher). DRIPs can also be reinforced with monthly or quarterly stock purchase plans so you continuously pump up your share ownership in solid stocks.

So a simple rule of thumb is to sign up for DRIP plans on your higher yielding dividend investments and stay committed to the plan for multiple decades to really come out ahead.

DRIP Benefits: With DRIPS, you have many things working for you:

–          the power of compounding quarter over quarter

–          dollar cost averaging because you end up buying shares in bad markets and good markets

–          significantly higher returns than non-DRIP plans

–          very low fees and the option of growing your share ownership through fractional shares

–          hundreds of well-regarded public companies that offer DRIP plans and several brokers that also automatically make reinvestments on your behalf so you don’t have to sacrifice on portfolio quality

–          and hassle-free reinvestment because everything is on auto-pilot.

What to Watch For: Make sure you check a DRIP plans minimum purchase requirements and fees before you signup (brokers are often cheaper than company sponsored plans). For example, if you’re planning on contributing $50 monthly to a DRIP plan but end up paying $10 in fees each month, you’re really losing out.

DRIPs have a longer exit process with a lot more paperwork. When you exit a DRIP, you typically receive money in a few days whereas money is credited to your account almost instantly when you trade shares through a broker. So check on a DRIP’s exit process, fees and payment timeframe.

Tax Implications: With a DRIP, you don’t get cash dividends but are still liable for taxes at year end. So make sure you put away enough to pay the tax portion of your dividend income. Non-DRIP stock holders who received cash dividends have a slight advantage in that they do not have to find other sources of cash to pay their dividend taxes. Tax implications only apply to taxable accounts, non-taxable accounts do not have to worry about DRIPS.

With DRIPs, the sooner you start and the longer you stay with them, the better. But pick your DRIP investments wisely after evaluating a company’s history and track record of dividend payments and increases. If you do your research well and stay invested long enough, your DRIP portfolio can significantly outperform the market.