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Advantages and Disadvantages of Dividend Reinvestment Plans

By: , dated January 25th, 2013

When the markets are going strong, investors can’t seem to buy enough stock to satiate their appetites. However, when a bear market appears and the Dow and S&P 500 both dip by 15% or more for extended periods of time, investors flee, and are unlikely to return if the losses they incurred were substantial. While this may seem perfectly logical, it can actually be the wrong path to take. The reason is simple: the stock market continues to be the most stable and reliable investment option when a long-term perspective is taken. In fact, the stock market has grown by an average of 11% over the past four decades. Were there bad periods where the bears sapped stock prices and caused losses? Sure. But, if investors held onto those stocks instead of panicking and selling (another way to ensure that stock prices plummet), they may have come out much farther ahead in a year or two. Therefore, investors may want to consider an investment option that removes the temptation to sell-off during a downtrend, while still buying stock in a solid, quality company. Stock dividend reinvestment plans are excellent options for investors in the market for the long haul and who are looking to buy quality stocks for their portfolio.

Dividend reinvestment plans are not managed by brokers or other financial experts. Instead, these special plans are actually offered by the same companies that investors are buying stock in. The basic premise of a dividend reinvestment plan is to reinvest dividends back into the company. This reinvestment comes in the form of additional purchases of stock – thus, there are no cash payouts. Such plans even sell fractional shares of stock to investors, so every dime of profit is sunk back into the company, and the investor then owns more stock.

There are over 1,000 corporations currently offering stock reinvestment plans to investors. Many allow investors to make weekly investments while others may only allow them quarterly. Companies love such plans, because it affords them easy access to capital at low-interest rates. The company does not increase its debt burden, but still has the capital it needs to increase future earnings. Plus, businesses love long-term investors who are willing to stay for the long-haul, as they help stabilize stock prices, and reduce frequent trading and the associated price fluctuations.

Benefits to an Investor

While larger investments will naturally lead to larger profits (when successful), it can be difficult for many to set aside large chunks of cash for investing. But, with many corporations (even some of the big names!), an initial investment of $10-20 is all that is required to enroll in a dividend reinvestment plan. However, it is also necessary to already own stock in the company to be eligible, but owning a single share is often all that is required for eligibility in many stock dividend reinvestment plans.

Another common problem for investors is attaining large numbers of shares in one specific company. But, the great thing about a stock dividend reinvestment plan is that it allows investors the opportunity to buy significant numbers of shares in a company over a long period of time. During bear markets, investors can buy more shares at a lower cost while waiting for the bulls to reappear – but the key is to continually buy stock during all phases of the market cycle.

Investors also like dividend reinvestment plans because of their low-cost. By purchasing stock directly from the company, investors can by-pass broker fees and buy more stock per unit of money. In time, the additional shares of stock will contribute to significant gains in the bottom line as long as the stock price does, in fact, rise by the time the shares are sold.

As often happens in a bear market, people tend to sell off and cut their losses. But with a dividend reinvestment plan, investors are more likely to not only keep their stock, but also buy more.

Finally, while dividends are reported as capital gains, dividend reinvestment plans do not make any cash payout. While stock prices may rise, no capital gains tax need be paid until the stock is sold. The longer the shares are held, the lower the tax rate tends to be.

Disadvantages

While people like to see their investments grow until they are ready to retire or make a large purchase, it is sometimes necessary to liquidate in order to meet current obligations. Unfortunately, stock dividend reinvestment plans are somewhat difficult to liquidate. It is quite possible that the company will need to be directly contacted in order to sell the accumulated stock and exit from the plan. Some companies even require written requests from investors looking to opt-out of their stock dividend reinvestment plan (remember, companies like steady investors who are in it for the long-haul, so requirements like a written request are designed to discourage investors from cashing out of the plan).

Another issue that many investors have with stock dividend reinvestment plans is the fact that they are on their own. While there are no broker fees with such plans, this also means that there are no brokers helping investors make investment decisions. It is up to the investors to investigate and research potential companies and their dividend reinvestment plans. Therefore, to a certain degree, such plans actually carry more potential risk for novice investors.

Though stock dividend reinvestment plans make it more difficult to liquidate stock, and require more homework on the part of investors, the advantages make them very attractive for investors who are new to the stock market. Such plans may forego the potential dividend cash payout but they allow investors to build up a significant stake in a company over a period of several years. An 11% average annual return on the stock market in the past 40 years is not a myth – it is fact. Those that stay in the market for the long haul are more likely to see an 11% annual return on their investment than those who bail at the first sign of trouble.

This article was brought to you by the InvestorGuide Staff Writers and Editors.

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