With the ASX host to many dividend-paying stocks Australians have long been able to incorporate dividends into their investing strategy. Whether you want to build a portfolio from scratch or invest for income the local share market offers plenty of options. Many ASX-listed companies also offer dividend reinvestment plans otherwise known as DRIPs or DRPs.

A dividend reinvestment plan provides investors the opportunity to reinvest dividend proceeds back into a stock in order to acquire additional shares. Investors may purchase these shares without paying any brokerage fees. In some instances you may even be able to acquire new shares at a discount.

While participating in a dividend reinvestment plan might sound like a compelling choice you should consider a number of issues. But first let look at some of the advantages of DRPs.

Advantages of Dividend Reinvestment Plans

No brokerage fees

Dividend reinvestment plans are free to participate in. There are no brokerage fees that you might otherwise pay if you were buying shares on-market. These savings may start out small but they can add up over the long-term once you own various stocks that pay dividends twice per year. No brokerage also means that fees don't eat into your potential returns.

Discounted share price

A limited number of companies provide investors with a discounted DRP. In such instances new shares may be acquired at a discount to the volume-weighted average share price over a set period. This policy may allow you to purchase shares at a cheaper price than on the ASX. Discounts are typically in the range of 1-5% which could provide you with just enough leeway to start with a small profit.

Capital management initiative

When a company pays dividends to its shareholders it uses its own cash to fulfil that declaration. On the other hand if you opt to participate in a dividend reinvestment plan you will be issued new shares in the company. Although this means more shares are created the company retains more of its earnings to grow.

Compounding and dollar cost averaging

Dividend reinvestment plans are similar to the concept of dollar cost averaging.By participating in a DRP you effectively purchase additional shares at regular intervals increasing your holdings. These purchases take place at different prices removing much of the decision making from your investment process. Since your total holdings increase with each reinvestment future dividend proceeds and reinvestments compound.

Convenience and simplicity

Unlike placing an order on the market there is no minimum size for the amount you may invest through a dividend reinvestment plan. In addition you only need to nominate your participation with the share registry of the company offering the DRP. The process takes place automatically without any requirement for you to be involved.

Disadvantages of Dividend Reinvestment Plans

While DRPs offer many potential incentives you should also be wary of the consequences tied to this choice.

From a tax perspective the treatment of dividend reinvestment plans can be a little more complex. There is a greater burden to keep tax records. Generally speaking capital gains will be calculated on the basis that you received dividend proceeds and used those proceeds to acquire new shares. DRP discounts are incorporated into the purchase price. Franking credits are treated as per normal.

Nonetheless you should always speak to an accountant regarding the tax implications for a DRP based on your personal circumstances.

Another disadvantage of a dividend reinvestment plan is the lack of flexibility in managing your portfolio. Although you can opt out DRPs at any time if you remain a participant you will acquire new shares at the DRP price. There is a risk the DRP price could be above the market price.

New shares issued through a dividend reinvestment plan may also reduce portfolio diversification. This could arise if the DRP increases your holdings in a stock that represents a large weight of your portfolio. For this reason some investors prefer to receive their dividends as a regular source of income. This option provides more freedom to control your investment decisions or to use this money for lifestyle purposes.

Finally it is important to understand that dividend reinvestment plans may result in some dilution for shareholders. Share dilution refers to a decrease in a shareholder's ownership proportion when a company issues new shares. As more investors participate in a DRP more shares are issued but those who do not participate will see their holdings diluted.

Final Takeaway

Like any other investment decision you make you should always weigh up the pros and cons of dividend reinvestment plans. It particularly important that you assess each DRP on its own merits. This means that you should view one DRP as different to another in much the same way that every ASX stock is different.