In my office we have a coffee connoisseur.
He makes his cup of Joe in a French press twice a day with incredible meticulousness. First, he coarse grinds his beans at his desk by hand with a little manual machine. Then he puts it in his press, pours boiling water in it and gives it a stir. He waits precisely 4 minutes to the second before pushing down on the plunger and pouring the brew into his mug, mixing it with some hot milk he has just microwaved. It’s an absolute symphony to watch the preciseness of it all. It’s also so much damn work.
Me? I watch it in bemusement with my cup of drip Kirkland brand coffee. It’s the cheaper and easier way to get what I want – just like my investments.
What is DRIP investing?
DRIP stands for Dividend Reinvestment Plan, which are plans that many dividend paying corporations offer. For example, TSX ENB offers a $0.61 dividend per share. If you own 100 shares, you get $61 every quarter issued to you as a dividend. Hooray, right? You have cash in your hand. What’s not to like?
The problem is what do you actually do with that $61? Do you withdraw it? That doesn’t work if you’re in a registered account. Do you buy a few shares of another stock? Well, that’ll cost you in commission. Or do you just let it sit there?
A DRIP basically auto-enrolls you to take that $61 and reinvest it automatically into the company at no additional cost to you. The more shares you accumulate, the more dividend cash you get through the power of compounding.
What are the pros of DRIPs?
#1 It’s an easy way to get what you want without all the work.
Like my coffee connoisseur colleague brewing his cup of coffee, you can spend an extraordinary amount of time waiting for the perfect share price to throw your cash in, or you can take the easy route.
DRIPs incorporate the concept of dollar-cost averaging (DCA’ing), albeit on a much smaller scale. DCA’ing removes the emotional side of investing. So unlike grinding your beans, microwaving your milk, and waiting for the perfect moment, you’re letting your investments brew automatically for you with minimal effort. Some corporations will even offer a 3-5% discount off the share price for being a part of the plan as thank you.
#2 Your investment compounds immediately.
Stocks can be expensive, especially mid-to-large caps. If you want to buy at least 50 shares of a company, you’re going to need potentially thousands of dollars, ready to go. If you’re taking your dividends in cash, you could be waiting a while until you have enough to buy a stock.
DRIPs remove the opportunity cost of idle cash, increasing your time in the market. Over time, the additional regular share accumulation can create a hefty investment portfolio.
What are the cons?
#1 It can get complicated, tax-wise.
This complication arises only if you enrol in a DRIP in a non-registered account. Not only do you get taxed still on the dividend upon payout, but when calculating your capital gains or losses, the CRA takes the sell price of your shares and subtracts it from the average purchase price, or adjusted cost base, of your shares.
For example, if you bought 100 shares of a stock at $10 for $1000 total and sold it for $12, or $1200 total, your capital gain would be $200, right? Simple.
But what if you bought 100 shares of a stock at $10, had DRIP that added 12 shares at different prices to end the year at 112 shares, before selling just 100 shares for $1200 again. Your capital gain is not $200. Your capital gain is based on the $1200 minus the average cost of 100 shares from all 112 shares you own. For simplicity, let’s write it out:
Let y be the average cost per share from the 112 shares owned:
($12 sell price x 100 shares) – ($y x 100 shares) = Capital Gain
Make sense? If it doesn’t, all the more reason to see that DRIPs can be complicated for tax purposes outside of registered accounts.
#2 Just because a company offers a DRIP, doesn’t mean it’s a good investment
This is a no brainer – a company might offer an exceptional DRIP plan, but if all the warning signs of it collapsing are there, why invest more into a losing investment?
But the pros still outweigh the cons
All the major index funds, which traditionally outperform active investors, are technically DRIP’ing their dividend payouts from the companies they hold within the fund. This is why many index fund investors don’t see monthly dividend payments from whatever index fund they own, aside from the minimal annual dividend payout they get at the end of the year.
The managers of these passive funds understand that fundamentally, DRIPs are a smart way to grow the value of the fund while keeping costs low for investors.
So sure, while it may not be as exciting as tracking a share price and executing trades with amazing preciseness, it’s still the safest way to watch your money grow with minimal effort.
When it comes to investing and coffee making, I prefer the boring way, every single time.
Want to learn more about investing? Check out these posts:
- When Index Investing, I Skip the TSX
- Even though I have a pension, I still buy bonds.
- A Guide to Dollar-Cost Averaging