When you buy a company's shares, what are you investing in?
When you invest, you are becoming part owner of that company. Which means you’re buying the rights to their current assets, and the revenues they generate in the future. The earnings that the company will make in the future has a value, which is what drives the share price.
But the reason for you to invest isn’t so that your company makes money. It’s so that you make money.
There are two ways that can happen, share price appreciation (growth), and dividends.
What is a Dividend?
A dividend conveniently derives its name from the mathematical equation, a number divided by another number. In this case, the numbers are the total amount of a company's income to be shared with the owners.
As a shareholder, you are entitled to the declared amount for each share you own. The company then pays you, the owner, that amount of money on a set date.
Why are Dividends important?
As an investor, you want to grow your investments. Dividends is one way that can happen, as a company pays out some of its growth to you. Some companies pay out dividends so reliably, that people build their investment portfolios around them. Those companies, like Coca-Cola, have been paying a regular dividend each quarter for many many years, which can provide some comfort to investors. Those investors actually plan for that dividend to be paid as part of their financial plan.
DRIP, drip, drip
Building dividends into your financial plan will eventually lead you to talk of DRIP strategies. DRIP, or Dividend Reinvestment Plans, take the dividends that would have been paid out, and purchase more shares with those earnings. In this way, your investment can keep growing as you buy more and more shares with the earnings that you make. This is especially important for a few reasons.
Firstly, DRIP plans can avoid the additional transaction costs of purchasing more shares. Most consumer trading platforms charge a fee per transaction as trading commission. When using DRIP, those investments are made by the managing company, and not you. That means you can avoid those trading commissions, and keep more of your money working for you.
The second benefit is equally as important as cutting the fees. This is time in the market. DRIP plans take your “cash” earned from the dividends, and invest it immediately back into that stock. While the convenience shouldn’t be overlooked, the biggest benefit is that you don’t need to think about the investment. Taking the choice out of the equation helps you reinvest those monies faster, which cuts the incalculable cost of inaction..
Unfortunately, some DRIP plans are administered by third parties that have terrible fee structures. Coca-Cola is one such company. The administrators of that plan charge fees for each reinvestment, often in excess of what a private investor could achieve with their own trading platform. In those instances, it would be more advantageous to take the cash when the dividend it paid, and immediately reinvest back into those stocks. While more labor intensive, this DIY approach can cut down on the total fees paid.
The DIY plan also doesn’t carry the second benefit. You need to make that conscious choice to reinvest, which opens you up to all sorts of biases.
If a DIY DRIP plan is your investment strategy, you need to set clear operating principles of when to use those proceeds to buy additional shares. It’s far too easy to succumb to the mentality that “the price will be lower tomorrow”. Those market timing games are addictive, and almost never pay out in your favor.
Dividends can provide an exciting and different investment strategy. Whether you’re a DIYer or sign up for a commercial DRIP plan, dividends provide an excellent avenue to grow your investments, or simply provide cash flow for you to enjoy.
Dividends are a privilege, not a right. A company can decide to stop paying dividends at any time. If you’re looking into a DRIP investment strategy, you should be focusing on companies with a long (10+ years) history of paying dividends. Those companies are less likely to cancel their dividends, due to shareholder (owner) expectations.