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4 Rules for Successful DRIP Investing

Rebecca Lake

Dividend reinvestment plans, or DRIPs for short, offer a simplified path to portfolio growth.

Rather than receiving dividend payments quarterly or annually, stock dividends are put to work another way.

"As the name suggests, it's an investing program that drips small amounts of money on a regular schedule to purchase additional shares of stick the investor already owns," says Graham Williams, co-founder of Optimist Retirement Group in Scottsdale, Arizona. "This is a simple and convenient way for investors to continuously purchase more shares over time."

DRIP investing can save time and effort by putting one segment of an investor's portfolio on autopilot. There's no need to decide which shares of stock to buy or when, as stock purchases are made automatically. It's a simplified way to take advantage of dollar-cost averaging, which dictates purchasing stock shares systematically over time.

"By investing dividends immediately back into additional shares, investors are purchasing more shares when prices are down and fewer when prices are up," Williams says. More shares purchased means more dividends in the future.

Another advantage of utilizing a DRIP strategy is cost.

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"One of the best things to remember about DRIP investing is that it is almost always commission-free," says Mitchell Walk, president and founder of Florida-based Retirement Wealth Specialists.

While more brokerages are offering commission-free trades, not having to worry about commission fees to reinvest dividends is a plus. The key to finding success with DRIP investing is knowing how to manage those investments.

Here are the most important rules to follow when incorporating DRIP programs into a portfolio:

-- Invest long term.

-- Choose the right DRIP stocks.

-- Be mindful of taxes.

-- Stay balanced with DRIP investing.

Invest With the Long Term In Mind

Purchasing DRIP funds or investing in stock DRIPs isn't a strategy that's designed to deliver quick wins where returns are concerned.

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The No. 1 reason to have DRIPs in a portfolio is to increase investment income by buying more shares without tying up income or cash flow, Walk says. When dividends are reinvested into additional shares or fractional shares of dividend-paying stocks regularly, the result can be slow and steady investment gains.

"To be successful with DRIP investing, you must do your due diligence and understand this is a long-term investment," Walk says. "DRIP programs are not ideal for investors with short-term growth goals."

DRIPs may be better suited to an investor who's still in the thick of the accumulation phase of portfolio building. The further away an individual is from needing to tap dividends for income, the better.

"The power of compounding can't be understated," says Michael Tanney, director at New York-based Magnus Financial Group.

He says dividends can be an extremely powerful method for capturing longer-term outsized returns.

Choose the Right DRIP Stocks

When selecting DRIP funds or dividend-paying stocks to invest in, know what you own is a good rule to follow.

"Identify companies that resonate with you or your family on a personal level," Tanney says.

An investor who is partial to Johnson & Johnson (ticker: JNJ) products, for example, may choose to invest in that stock for dividend growth. Someone else may lean toward Hormel Foods ( HRL) if they prefer that brand. Both companies are dividend aristocrats, meaning they've increased their dividend payout to investors for 25 consecutive years or longer.

It's important to research DRIP stocks that are unfamiliar before venturing in. Walk says the number one mistake investors make with DRIP account investing is choosing stocks based on what's trending without doing any research into the company first.

[See: 54 Dividend Stocks Boasting 25-Year Dividend Growth.]

"This is all too often the investor's downfall," Walk says.

Looking at a company's history and growth, including how its dividend payout has moved over time, is essential in choosing DRIP stocks and DRIP funds that are most promising for reaching individual investment goals and objectives.

Just don't make the mistake of focusing on dividend yield alone to evaluate a DRIP investment, Tanney says. "Investing based solely on the current dividend yield doesn't necessarily or accurately provide a snapshot of the potential risk/reward profile of the investment," he adds.

Be Mindful of Taxes

One aspect of reinvesting dividends wisely means minimizing taxes on gains as much as possible.

"A common error DRIP investors make is forgetting taxes are owed on the dividends used to purchase more shares," Williams says. "This is especially a problem for investors in high tax brackets who are still in the accumulation phase."

The last thing investors need is to receive a surprise tax bill on reinvested dividend income. Williams says investors should consider using a DRIP program in an individual retirement account or a similar tax-advantaged account to manage tax liability.

"IRAs and other retirement accounts are the ultimate long-term investments, so we want to keep our money working all the time," he says. "These accounts also protect investors from paying taxes on those dividends they reinvest, so no issues arise with having to pay taxes and not having funds to do so."

When selling DRIP stocks in a taxable account, take the timing into account and harvest losses wisely.

"If you have gains, make sure that you're selling only long-term capital gains," says Wesley Botto, partner at Botto Financial Planning & Advisory in Cincinnati. "You could accidentally sell reinvested dividends from less than a year ago that will cause you to incur short-term capital gains."

Stay Balanced With DRIP Investing

Utilizing DRIP programs can simplify portfolio management but it doesn't mean investors can afford to be completely hands-off when reaping the benefits of dividend-paying stocks.

"You'll need to monitor your overall portfolio to stay at the desired allocation," Botto says.

Using a DRIP strategy that includes multiple stocks can do a better job of keeping investments in balance and well-diversified, Botto says. For example, there are more than 50 companies that fall under the dividend aristocrat umbrella. Those stocks represent a broad range of sectors, including health care, financials and consumer staples, allowing for diversification.

Williams says individuals who take the "set it and forget it" approach with dividends should be aware of whether each DRIP investment they own is a buy or hold. Once they know that, they can and should adjust their allocation as needed.

"Don't hesitate to liquidate a position you're currently DRIP investing into if it no longer meets your needs," Williams says.

He equates it to investing cash. "Don't make the mental account error of discounting dividends as free money -- it's your money, same as your paycheck so invest it wisely," he says.

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