It all seems like a pretty simple process. Put some seed money in, make regular contributions, and by the time you’re a bit grey and podgy, you’ll have a mountain of money at your disposal.
You won’t get too far into your financial education without reading about the power of compounding. All you have to do, or so it seems, is sit back and watch the money-pile grow.
But…if only it were that simple.
The problem is that you might need the money for something else…like a deposit to buy a house. You’re likely to choose a place to live in now over the potential of compounded wealth possibly decades down the track.
Each time you accumulate a decent pile of money, something pops up and snatches it right out of your hands. On top of that, your regular income disappears into a stream of bills.
Get the market to work for you
The good thing about the stock market, however, is that you can grow your wealth without having to keep tipping in your own money.
Yes, you need to get a start. You need to put up some capital, but it’s not as much as you might think.
How much? The answer is whatever you can afford without having to raid it every time you receive an unexpected bill.
You want to set it up so that, once you’ve put your money in, you get the market to work for you.
One way you can do this is through a dividend reinvestment plan. Or ‘DRP’ for short. A DRP enables you to receive shares in a company in lieu of receiving a cash dividend.
Not all companies offer DRPs. In fact, most of the 2,300 or so companies listed on the ASX don’t offer them. It’s typically only the biggest and most profitable companies — that is, the blue-chips — that offer DRPs.
But how does it work?
When a company declares a dividend, and it has a DRP, you can elect to receive the equivalent of the dividend in the form of shares. Some companies will let you split it between shares and cash.
The good news is that companies often offer these shares at a discount to the market. Not a big discount — around 2–2.5% — but this too is a hidden strength of how DRPs help to grow wealth.
Not only are you continually expanding your shareholding — and your asset base — you are continually receiving shares at a discount to the market. And not paying any brokerage or other fees to do so.
With most of the blue-chips paying dividends twice a year, the other good news is that your shareholding also increases twice a year too.
That might not add up to anything significant at first. But, within a few years, you’ll be surprised how much your shareholding has grown. Do it for a decade and more and the results could be staggering.
Take a boring old bank stock with a yield of around 5%. By electing to participate in a DRP, you could grow your shareholding by almost 35% within a few years.
If you started with 1,000 shares, your first allocation would be 50 shares. However, the second dividend for the year would net 52 shares, and so on.
The second year would net 113 shares, and 124 in the third year. By the end of the third year, you’d own 1,340 shares. Go out to five years and this jumps to over 1,600 shares.
And when you’re ready, you can always switch back to receiving cash dividends instead. When you do, however, you’ll be receiving them on a much larger number of shares.
What’s the catch?
Of course, it would be great if you could set your DRP in action and sit back and watch your shareholdings grow. However, the taxman is never far away.
Always get your own advice; however, the ATO sets out a number of guidelines. Shares that you acquire through a DRP are treated as cash income, so you will need to pay tax on them each year. In doing so, though, you’re copping pain now for what could be a much bigger asset pile down the track.
Another thing is that each new batch of shares forms its own cost base for future capital gains tax calculations. Own the shares for a decade, and this will swell out to 20. That’s something that will make your accountant wince.
It’s not a set-and-forget process. You still have to decide whether you want to own the shares. You also need to be careful that your growing shareholding doesn’t start to dominate your portfolio.
However, if you get it right, and can afford any tax obligations in the meantime, DRPs can be a great way to build your wealth. To give investors the choice of income now — or in the future based on a bigger holding — stocks that offer DRPs are one of the things we look for at Total Income.
All the best,
Editor, Total Income