Dividends are payments made from a company to its shareholders. A company may pay out a dividend to shareholders if the company deems that there is no potential gain in reinvesting the company’s profits back into the growth of the company. In such cases, the company’s profits are returned to shareholders in the form of dividends.
Many stock brokers and online brokerage houses allow you to reinvest your dividends to purchase additional shares (or fractional shares) of the same stock. It is almost always a good idea to reinvest your stock dividends. This is because of the basic principle of compounding. Compounding, when applied to stock dividends, means that additional shares of stock purchased with dividend payments will eventually result in additional dividend payments that are higher at each subsequent dividend payment (assuming that the dividend payments per share remains the same or greater).
Compounded dividend payments allow you to grow the income generated by your stock holdings slowly and steadily by reinvesting your investment yields back into the investment. At each turn, you own a progressively larger share of the company whose stock you own, which means that you are entitled to a progressively larger share of the company’s profits in the form of dividends. The principle behind dividend reinvesting is similar to the principle behind compound interest.
Many companies allow you to purchase shares of stock directly from the company, and to automatically reinvest dividends into additional shares as dividends are distributed. Such a program is called a “DRIP,” which stands for “Dividend Reinvestment Plan.” DRIPs allow you to take advantage of dividend reinvesting without having to pay any brokerage fees.
If you plan to invest heavily in dividend stocks, you should try to invest only in those companies whose dividend payouts have increased steadily for several years. Steadily increasing dividends demonstrate that the company is stable enough to return its profits to shareholders and that the company has a steady stream of revenue. If a company pays out too much in dividends (higher than around 4 or 5 percent), then the company may not be able to sustain its dividend payouts, or the company may be in worse shape than it may appear on paper. Steadily increasing dividends around 4 percent or less are usually safe long-term investments whose dividends you can reinvest to grow your share of the company.
Remember that, in addition to reinvesting your stock dividends, you should continually purchase additional shares of stock. Continually purchasing additional shares of dividend stocks also serves to increase subsequent dividend payouts and allows you to dollar cost average your investments. Dollar cost averaging means that you buy fewer shares of stock when the stock is high priced, and you buy a greater number of shares of stock when the stock is lower-priced. Rather than trying to time your stock purchases, just invest regularly over a long period of time, and be sure to reinvest your dividends back into additional shares of the stock. The combination of dollar cost averaging, dividend reinvestment, and company growth should allow you to take full advantage of investing in individual stocks for the long term.