Drip

Source: Pixabay.

There is a secret to investing success that some investors don't know: the power of dividend growth investing. It is one of the most powerful long-term wealth-building tools available to help achieve your financial dreams.

For example, a Morgan Stanley study found that between 1930 and 2012, 42% of the S&P 500's return was a result of dividends. 

Similarly, many income investors' favorite dividend aristocrats (companies that have grown their dividends for at least 25 consecutive years), such as Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), 3M (NYSE:MMM), and Aflac (NYSE:AFL), have proven to be fantastic long-term investments.

JNJ Chart

However, the true power of dividend growth stocks isn't just their ability to beat the market, but rather their ability to supercharge your portfolio through dividend reinvestment:

Company

Current Yield

Annual Return 1986-2014 Without Dividend Reinvestment

Annual Return 1986-2014 With Dividend Reinvestment

Aflac

2.5%

12.46%

13.98%

Johnson & Johnson

2.7%

11.41%

13.74%

3M

2.3%

8.81%

11.64%

Proctor & Gamble

3%

10.83%

13.33%

Portfolio Average

2.63%

10.88%

13.17%

S&P 500

1.95%

8.56%

9.68%

Sources: Yahoo Finance, Multpl.com, YCharts.

A portfolio of these four companies would have beaten the market by 27% annually over the last 28 years. However, with dividend reinvestment, that outperformance jumps to 36% annually. 

To understand just how powerful that is, consider the comparative portfolio values of $10,000 invested 28 years ago in these four companies, with and without dividend reinvestment:

  • No dividend reinvestment: $180,256
  • With dividend reinvestment: $319,504

By simply reinvesting the dividends, you would have increased your overall return by an incredible 77% and netted an extra $139,000.

The amazing power of dividend reinvestment to turn decent returns into great returns is why I want to teach you about one of the market's most powerful investing tools: the dividend reinvestment plan, or DRIP. 

4 reasons to consider DRIP investing
There are four main reasons all income investors should consider enrolling in a DRIP.

First, a DRIP automates the reinvestment process and helps you avoid one of the biggest pitfalls of investing: market timing. As my Motley Fool colleague John Maxfield recently explained, investors have a terrible habit of pouring money into markets at their peaks and taking money out when they crash. 

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This is why over the last 20 years, investors have underperformed the market by 4.2% annually. Automatically reinvesting dividends is one way of dollar-cost averaging, and it's a useful tool to help fight the psychology that makes market timing so harmful to most investors.

The second reason to love DRIPs is low costs. Over 1,600 companies offer direct DRIP plans for their shares, and most brokers (except for interactive brokers) also offer this option, commission-free.

DRIPs also allow you to maximize your compounding power by purchasing fractional shares. This is particularly useful if you're investing in stocks with expensive share prices. Most brokers offer this feature as part of their DRIP plans.

Finally, some companies offer DRIP investors discounts on shares -- typically 1% to 5%. Examples of these include Piedmont Natural Gas (NYSE:PNY), Healthcare Realty Trust (NYSE:HR), and Aqua America (NYSE:WTR), all of which offer a 5% discount on shares acquired through their DRIP program.

The downside of DRIPs
So, given the powerful benefits of DRIPs, is there any reason you might not want to participate? I can think of two.

First, if your dividend stock isn't one that offers a direct DRIP program, then the only way to enroll in this kind of program is through your broker, which may not offer it or may have limitations. For example, your broker may not allow fractional share purchases. In addition, brokers may require stocks to meet certain criteria in order for you to purchase them through a DRIP, such as a $5-per-share minimum price or minimum daily share volume.

However, the biggest reason you might choose not to enroll in a DRIP is the loss of control over where your dividends are going. For example, say one of your dividend stocks is overvalued and another is severely undervalued. You may want to take the dividend income from the overvalued stock and invest it in the undervalued stock in order to improve your long-term returns and lock in a higher yield. Of course, this option would entail paying broker commissions, which investors need to keep an eye on.

Engage auto pilot
DRIPs can be a powerful tool to help long-term income investors maximize their wealth creation. These programs help automate the investment process, lower investing fees, increase compounding power through fractional share purchases, and even boost returns through the share discounts offered by certain companies. However, investors need to be aware of the limitations of DRIPs, such as limited eligibility at certain brokers and the loss of control over dividend income. If DRIPs sound like something you'd be interested in, I suggest you find out whether your dividend stock offers such an option or check with your broker to see what (if any) limitations they have.

Adam Galas has no position in any stocks mentioned. The Motley Fool recommends 3M, Aflac, Aqua America, Johnson & Johnson, Piedmont Natural Gas Company, and Procter & Gamble. The Motley Fool owns shares of Johnson & Johnson. Try any of our newsletter services free for 30 days. We Motley Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.