The two ways to make money on stocks are through capital gains and dividend income.

Capital gains come from selling a stock for a higher price than you purchased it. In the case of shorting, the capital gain would come from buying back a stock at a lower price than you short sold it.

Dividend is a share of a company’s profits that is distributed to shareholders. This allows an investor to get some cash from his/her stock holding without needing to sell the stock outright.

It’s also possible to parlay dividend income into more capital gains by reinvesting the cash into the stock.

Reinvesting for Growth

Some companies offer dividend reinvestment plans (DRIP). If you participate, as a shareholder, instead of paying you the regular dividend, the company automatically uses that dividend to purchase additional shares of the stock at no charge (fractional shares are allowed and are totally normal).

Some companies offer DRIP shares at a discount to the market price, so you save a little money. On the other hand, in the future when you want to sell the DRIP shares, you will need to redeem them through the company, not on the open market.

Back in the day when brokers charged commissions, DRIP can end up saving investors a decent amount of money on trading cost over time. Nowadays, that no-charge aspect isn’t a big deal anymore because discount brokers no longer charge any commission on most U.S. stocks anyway, but having shares automatically accumulate is still convenient.

Brokers typically offer the option of reinvesting dividends when you buy a stock. It’s usually as simple as checking a box or making a choice via a dropdown menu. If you choose this option, when the dividend comes into your account, the cash is 100% automatically used to purchase shares of the same stock.

Technically, this action is not a DRIP because you reinvest through the broker, not the company, but the effect is the same. Plus, through a broker you can participate in automatic reinvestment on many stocks in the same account. In the case of DRIP, for each company you can only buy that company’s own stock.

Similar to Interest Compounding

As mentioned, when you reinvest dividends, over time you own more and more shares of the stock. If the stock goes up, then you will make additional money by having more shares invested. Over time, the reinvestment of dividends can meaningfully add to your return. This is similar to the idea of compounding with interest rates, where you earn interest on the interest you received previously and that increases your overall return.

However, unlike in the case of a fixed-income instrument like a CD, it’s entirely possible that the stock actually goes down over time. In this case, if the stock price falls after you reinvest dividend, because you own more shares of a declining stock, you will end up with a worse return than if you did not reinvest the dividend.

But, stocks tend to rise over time. And if you happened to have a stock that’s mired in a long-term downtrend and it’s consistently doing poorly, hopefully you would have paid enough attention to sell it before things get too bad, so dividend reinvestment shouldn’t hurt you very much.

Beware that in taxable investment accounts, the dividend that’s reinvested is still considered to be income received, so they are taxable. Thus, from a cash-flow perspective reinvesting dividend is a net outflow. In other words, you never actually received the cash from the dividend, which is now tied up in a stock, but you still have to pay taxes on the dividend.

Therefore, if you actually need to use dividend income to help meet your living expenses, it’s best not to reinvest it. If you have time to let your investments grow, however, in most cases reinvestment would make sense.

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