If you agree with me that any currently unneeded cash that you receive from your equity investments should be reinvested, you generally have two options: using a DRIP, or reinvesting your dividends on your own. The two choices are not mutually exclusive (you can use them in conjunction, depending on where and how your stocks are held), but investors usually seem to favor one over the other.
DRIPs, or dividend reinvestment plans, are available through most discount brokers, transfer agents, and directly from some companies. If your account (or some its separate holdings) is enrolled in a DRIP, every time one of its holdings pays out a dividend, that cash is automatically converted into more shares of that holding, at the current market price.
Advantages of a DRIP
1. Dividend reinvestment programs are either free (most discount brokers and companies from which you can buy shares directly) or cost very little (transfer agents and some companies charge a small fee). Paying little to no commissions for regularly buying more shares is advantageous for those accounts that do not receive large dividends and/or regular deposits of fresh money. That is, if you receive $50 worth of dividends per month and you do not deposit more funds with which to invest, reinvesting manually will eat a large chunk of your dividend because of broker fees. With a DRIP, however, you will incur little to no additional expenses.
2. Dividend reinvestment is automatic. You can buy the holding and forget about it. Every time a dividend is paid, you get more shares, increasing your future dividend payments and hopefully compounding your returns.
3. DRIPs give you "investing discipline," as they make you buy additional shares on a regular basis, no matter what the market is doing. You get more shares when they're cheap, and less when they're expensive.
4. DRIPs enable you to buy fractional shares. They allow you to reinvest the full dividend you receive. Suppose you get a $50 dividend payment from a stock that trades for $60 a share. Without fresh money, you generally (excluding scheduled investments with brokers like Sharebuilder and Sogotrade) cannot reinvest that $50 until either the share price goes down, you get another dividend payment, or you deposit more money.
5. Some companies and closed end funds give you a discount for dividend reinvestments that can be a few percentage points lower than the current market price.
Drawbacks of a DRIP
1. You can only reinvest in the company that paid out the dividend. Say company XYZ pays you a dividend. Suppose that at the time your asset allocation would fare better if that money were put into company ABC. You cannot reinvest XYZ's dividend in ABC in a DRIP.
2. Reinvestments are made at market price on the day of the dividend payout. Short of not making a reinvestment, you have no control over what price you pay for additional shares.
3. While using a DRIP over a long period of time can be very rewarding, when the time comes to sell your holding you may have a tax accounting nightmare on your hands. For example, if the stock in your DRIP pays a quarterly dividend, after 20 years you will have 80 DRIP purchases. They will all be at least partially in fractional shares and at different prices. Be sure to save all your account statements to reduce your frustration at tax time. (Note that this type of problem is faced by anyone who makes regular investments in the same holding, so it is not faced solely by users of DRIPs. However, having regular fractional share purchases may pose an additional burden on some investors. Of course, if you already pay an accountant, let him or her worry about it. Additionally, a DRIP in a tax deferred account won't face this problem.)
Reinvesting Dividends By Yourself
Reinvesting dividends on your own can be done in a number of ways. These include, but are not limited to, reinvesting the entire dividend, reinvesting a part of the dividend, and adding the dividend to fresh money for investment in the same or a different holding.
1. By manually reinvesting your dividends, you have full control. You choose
a. when to reinvest and at what price: market timing.
b. how much to reinvest: for example, you might want to keep some of the dividend for use for other things, such as having extra pocket money or buying someone a gift.
c. what holding to reinvest in: your asset allocation may require more money to be placed in another holding.
2. If you make regular investments already, say $x a week or month, if you add your dividends to this amount, you incur no extra fees. That is, if you regularly invest fresh money, you will have paid the commission anyway; adding the dividend to it costs you nothing.
3. If you receive large dividend payments, fees incurred from reinvesting them manually may be negligible. For example, paying a $7 commission for reinvesting a $2,000 dividend payment will have little negative effect on your returns.
Disadvantages of Reinvesting Manually
1. By manually reinvesting your dividends, you have full control. You choose
a. when to reinvest and at what price: most investors are terrible market timers.
b. what holding to reinvest in: you might favor the holdings that have been doing well and might be too expensive while neglecting holdings that would benefit from averaging down.
2. Unless you make automatic scheduled investments at brokers like Sharebuilder and Sogotrade, you can only buy whole shares. As a result, you will most likely be unable to reinvest your entire dividend. Moreover, if your dividend payment is less than the price of one share and you do not deposit fresh funds, you will not be able to reinvest that dividend at all (until your dividends accumulate, which in some cases may take a long time).
3. If you receive small dividend payments and do not regularly deposit fresh money for investing, brokerage commissions will take a large chunk out of your reinvestments.
4. By choosing to reinvest your dividends by yourself you will miss out on the discounts that some companies and closed end funds provide for reinvested dividends.
5. Note the similarity between #1 in the advantages and #1 in the drawbacks. Reinvesting dividends on your own requires self enforced discipline as well as at least moderate monitoring of your holdings. You have to keep track of when dividend payments are received and will have to decide where to put them to work. Many investors end up having dividends pile up in their accounts, often earning little to no interest.
My opinion is that DRIPs are almost certainly the best option for investors with small accounts who do not invest fresh funds on a regular basis.
Reinvesting manually may be advantageous for investors who receive large dividend payments and/or regularly invest new money. Reinvesting on your own requires discipline as well as more frequent account monitoring.
Computershare is a transfer agent that allows investors to buy stock from a number of companies without the use of a broker, with free or low fee additional investments and dividend reinvestments.
While their number is growing fewer due to the expenses involved, some companies still offer direct investment plans with DRIPs. If you are interested in a particular company, visit the investor relations portion of its website. Wall-Street.com lists a few dozen companies that offer direct stock purchases, but I am not sure how accurate or complete the list is.
Zecco is a discount broker that currently gives you 10 free trades per month if your account's value is $2,500 or over. This can make it feasible for those investors who would most benefit from DRIPs to reinvest dividends on their own. I plan to have a Zecco review on this site at some point in the future.
Sharebuilder (review here) and Sogotrade (review here) offer low monthly fee packages that may also make it manageable for investors who receive small dividend payments to reinvest their dividends manually.