Harness the power of reinvested dividends

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My recent column on the importance of reinvesting dividends elicited more than the usual amount of reader feedback. (Read the column online at tgam.ca/EC78)

Some of you wrote to tell me that, by patiently reinvesting dividends over many years, you've achieved gratifying results in your own portfolio. This shows that compounding isn't just a theoretical concept: It's a powerful force that investors can easily harness to produce returns they never thought possible.

"I am a great supporter of dividend reinvestment plans [DRIPs]," one reader wrote. "DRIPs would have made us all rich had we the foresight and the patience to invest for the long term."

Several readers also sent in questions. Today I'll answer some of them.

You mentioned a "true" DRIP and a "synthetic" DRIP. What is the difference?

A true DRIP, also known as a traditional DRIP, is operated by the company's transfer agent – a third-party firm that maintains shareholder records and handles dividend payments, among other things. In Canada, the two largest transfer agents are Computershare and CST Trust.

The big advantage of true DRIPs is that they allow you to purchase fractions of shares, so every cent of your dividend will be reinvested. Synthetic DRIPs, on the other hand, are operated by your broker and usually permit only purchases of whole shares. That means a portion of your cash may not be reinvested. For example, if you receive a $30 dividend and a stock is priced at $20, you will buy one share and have $10 in cash left over.

You can find more information on DRIPs at www.dripprimer.ca.

Your column featured returns for Royal Bank. Does reinvesting dividends work for other companies?

Absolutely. Royal Bank was just an example. If you believe a company's stock price will rise over time – and you shouldn't own it if you don't – then reinvesting your dividends to acquire more shares will be beneficial.

Also, you don't necessarily need to enroll in a DRIP and reinvest your dividends in more shares of the same company. Many investors prefer to let their cash accumulate for several months until they find something attractive to purchase – it could be a stock you already own or a new one. The downside is that you'll usually have to pay a commission, but with trades costing $10 or less, it won't have a material impact on your long-term returns.

If a company gets into trouble, reinvesting dividends would be a bad idea, wouldn't it?

It certainly could be. Reinvesting a dividend is really no different from taking money out of your bank account to invest. In both cases, you are increasing your exposure to a stock, so you'd better be confident about the company's ability to turn itself around. If you have doubts, you shouldn't even own it in the first place.

I have seen people reinvest dividends as share prices tumble – Yellow Media comes to mind – because they were seduced by the rising yield and wanted to "average down" their cost. That turned out to be a terrible idea because the stock kept falling and Yellow Media eventually eliminated its dividend.

Does reinvesting dividends work best in registered accounts, or non-registered accounts?

Synthetic DRIPs can be used in registered accounts (RRSPs and TFSAs, for example) and non-registered accounts. Traditional DRIPs, on the other hand, are only available for shares held outside registered plans. Something else to keep in mind: If you reinvest dividends inside a registered account, you don't have to keep track of your adjusted cost base (ACB) for tax purposes, but you do have to track your ACB if the shares are held outside a registered plan.