The share market is full of jargon which may not be familiar to the new investor. A term which is used frequently is DRP. This acronym means “Dividend Reinvestment Plan”. In this article we discuss the reasons why investors may want to take it up, and the potential downsides.
Definition of dividend reinvestment plan
Companies can pay their dividends to entitled stock holders through stock as opposed to cash. Some companies may offer DRP shares at a discount to market prices.
Why do companies offer DRP’s?
Companies are encouraging stock holders to reinvest their dividends back into the company through DRP’s. It also allows companies to keep cash in their reserves so they can use it for other purposes.
Why do investors take up DRP’s?
- New shares can be taken up via a dividend reinvestment plan free of brokerage. This can help increase returns over time as the shares have been taken up without transaction fees.
- Investors can slowly grow their investment over time through reinvesting their dividends.
- Investors do not need to take any action when taking up a DRP. Once the DRP election is selected, their holdings will be automatically reinvested with dividends via shares.
- This exercise can also assist the investor to compound their returns over time as funds are reinvested into the stock so interest is earning interest.
Downsides of DRP’s
- It can encourage investors to be complacent with their holdings and not actively manage their portfolio.
- The tax implication can be confusing for holders. All purchase prices of DRP’s need to be kept as the tax office considered the dividends received as shares instead of cash as an acquisition of the stock.
- DRP’s can encourage concentrations of small holdings. This means that investors can leave their portfolio undiversified with an insufficient number of holdings in other companies.
- As DRP’s are automatic, investors may be purchasing these shares in times when the shares are not performing well and this may not be best time to acquire more.
Lauren Hua is a private client adviser at Fairmont Equities.
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