Imagine you’re lying in bed and suddenly realize you have a leaky faucet in the bathroom and while you are trying to sleep you hear a “Drip” about every… let’s say 3 minutes. At first, you think “Ah… I have a drip. No big deal… it just caught my attention. I’ll fix that in the morning.” Then… “drip” (about 3 minutes later). “Drip” (about 3 minutes later). I’m willing to bet by the third “drip”, you’re out of bed trying to tighten the faucet only to return, close your eyes and hear… “drip”. After about an hour, you’ve now heard 20 drips and have fully taken on insomnia… you’re about to lose your mind. Or worst yet… that “leak” is coming from the ceiling. At first you put a bucket down, but realize after a couple of hours or so of “drips”, that a drip fills the bucket causing you to have to dump the water or face overflow and more issues.
Annoyed?
Absolutely… this would drive me nuts (and has in the past). But, take this analogy and let’s visualize how a “Drip” is a good thing in investing.
A DRiP is a Dividend, Re-investment Plan. Here’s the basics to how it works: Imagine now that you decide to research and buy a stock that pays a dividend. I’m going to use an actual stock but for sake of you running out and buying this stock, I won’t reveal the actual stock symbol. (In our Coach’s workshops, we like to describe the concept using real world examples… our “financial athletes” seem to appreciate this technique.)
We’ll call this stock XYZ and the symbol will be… you guessed it, XYZ.
XYZ, as I write this, is selling for $8.40. When I go and look up XYZ on Yahoo Finance (finance.yahoo.com), I see that it pays $.05 cents every month for 1 share of XYZ. If you do some quick math, $0.05 cents x 12 months equals $0.60 cents a year. (Small side-bar: some stocks pay dividends monthly, some quarterly or every 90 days or 3 months, some pay once a year. It all depends on how the company chooses to pay their dividends. The concepts still works the same though).
Now, you might say to yourself, “$0.60 cents a year… good one Coach. That’ll buy me… just about nothing!!”. Ok, fair enough, but stick with me… if you take $0.60 cents and divide it by your cost to buy XYZ (here at $8.40), you’ll notice that you’ll make about 7.14 % by doing NOTHING! That’s right, your stock will do the work for you and will pay you about 7.14% each year (granted that they don’t change the dividends they payout, etc… but that is for another blog. We’ll assume here that they have a good track record of paying consistent dividends). The 7.14% you calculated is called the Dividend Yield.
So, let’s say you buy 100 shares at $8.40. That’s $840 you have invested in XYZ stock. How much will you make in dividends now after one year? If you guessed (or calculated) $60, you’d be right (.60 cents x 100 shares is $60.00).
Ok. So what’s the DRiP part? Glad you asked. Imagine again how annoying that “drip” was… well this is a “good annoying” drip. Imagine next month in August (let’s say August 15th), XYZ declares their dividend of $0.05 cents per share like clock-work. You have 100 shares, therefore you get $5.00 ($0.05 cents x 100 shares). Nice work for doing nothing. Now lets “drip” that $5 bucks that magically appeared into the "portfolio bucket" and buy more of XYZ. XYZ next month (August) is going for… let’s say $8.00 (it’s down from where you bought it. Not to panic… markets go up and down). So, your $5 bucks can now buy how many shares of XYZ? If you guessed 0.625 shares, you’d be right ($5.00 divided by the price of the stock, $8.00). Now, you would have 100.625 shares of XYZ stock.
“Great Coach, I’m rolling in it now.” Hang on… stay with me. Here comes September… on 15 September, XYZ declares their $.05 cent per share dividend. How many shares do you have now? That’s right, 100.625. You don’t get paid a dividend on 100 shares. You will be paid on 100.625 shares. Take these shares and multiply by $.05 cents, and you will receive about $5.04. This is $.04 cents more than you got last month. Let’s say XYZ is still down in value, around $7.80. This would mean that you “Drip” your $5.04 and buy more XYZ at $7.80 or you would get about 0.645 shares of XYZ. You now own 101.27 shares of XYZ. I think you’re getting the idea, now let me show you a random chart. I made up the prices of XYZ for each month just to show you how many shares you would receive for that given example:
If you notice, over the course of the next few months (Oct-Jan), the price of XYZ goes down, thus causing your portfolio to go down in value as well. But, if you notice, during those months, you are able to “Drip” and buy more shares at the lower level. You are essentially using someone else’s money (XYZ’s money) to buy more shares for you. After one full year (on 15 JUL), when the stock is at $8.40 (I did this on purpose to show impact here), you made about $62.13 in dividends, actually making more in the Percent (%) earned (7.77% vs. 7.14% we originally figured) and your portfolio at the same price one year later is about $100 bucks more than what you paid a year back. That’s about 13% increase in portfolio value ($100 increase/ $800 original investment). And by the way... the next dividend payment you receive in August will be $5.38 (.05 x 107.686). In one year, your dividend payment has gone up $.38 cents per share or about 7.6% ($0.38/$5.00).
Now that is a “DRiP” that isn’t so annoying!! Imagine this over many years. That’s a bucket that fills up quickly and keeps on going! Again, this is a good problem to have. Now you know the basics to how Warren Buffet “DRiP’d” his way to becoming the 2nd wealthiest person in the world.
He used a Dividend Re-investment Plan for many of his positions… and he “let it ride!”
Got questions? Let us know. Like this one, let your friends know by hitting the “Like” tab. Know some other strategies, tell us!
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