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To DRIP or not to DRIP…

July 20, 2016

 

…that is the (dividend investor’s) question. Every stock market investor has to make this decision in their lives. So naturally everyone has their own opinions on the subject. There are some very basic pros and cons related to the decision that are helpful for all investors from beginners to experienced investors to understand.

 

What is a DRIP?

 

By definition a DRIP, or a dividend reinvestment plan, is when a company provides shareholders the opportunity to reinvest dividends provided by the company back into the company through purchase of shares in the company’s. This is typically instead of receiving a cash dividend payment from the company. Many times these transactions include fractional shares of a security.

 

Pros of DRIPing

 

Low Cost – No Fees

 

A typical DRIP program for most publicly traded companies is free for investors. The company offers the reinvestment at no cost. Due to this fact, the dividend amount is reinvested into the stock with no fees. Rule of thumb as an investor is that fees can substantially impact the long-term returns of an investor. DRIP investing goes a long way in reducing these detrimental costs.

 

For me personally, each transaction costs $7.95, if I were to have to pay that for every dividend I received and wanted to reinvest back in the companies, I’d barely break even. That may be an extreme example, but it helps illustrate how significant the cost savings of the dividend reinvestment programs can be.

 

Dollar Cost Averaging

 

Many retirement investing gurus will talk to you about dollar cost averaging your investments. Generally, you will hear about this in relation to 401k plans and the mutual funds you hold in them. The concept is that over time, every paycheck deduction you get invests in these funds whether they are at highs, lows, or in the middle. Over time the hope is that your investments got in at all the peaks and valleys and averaged out to a reasonable long-term cost basis. Just like the mutual funds, many will argue that reinvesting dividends every quarter or month will provide the same benefit. There will be more on my thoughts for dollar cost averaging in the cons section below.

 

Power of Compounding

 

Ahh, that 8th wonder of the world, compound interest. No investing feature puts compound investing on display more radiantly than dividend reinvestment plans. You have 100 shares of a $100 stock that pays a 4% dividend, at the end of year one you’re looking at approximately 104.06 shares of the stock. What’s not to like about that?? Didn’t even have to lift a finger. For those that employ and enjoy the “set it and forget it” approach to investing, this method is perfect.

 

Cons of DRIPing

 

No control over purchase prices

 

When I purchase a stake in a company, I like to believe I am getting a good deal. Of course, this isn’t how investing always works, there are good choices and bad choices alike. The goal in the end is to learn from your mistakes and make more good choices than the bad ones. DRIP investing takes away your control to purchase investments when you believe they are good deals. In a DRIP your investment is as of the dividend payout date, whether that suits you or not, this is not a choice.

 

This is important to me, while dollar cost averaging is good in theory, because it means you are steadily investing over a long period of time, it doesn’t make a whole lot of sense. Would you buy a car $5,000 over Kelly Blue Book? Would you pay $3/gallon for gas when there is gas for $2.50 across the street? I have the power to evaluate investments based on my own criteria and if a stock is overpriced, I wouldn’t buy into it, so I don’t see the logic in reinvesting my cash dividends there either.

 

Tax complications

 

This is probably more of a personal preference item more than anything, but here it goes. I like what I perceive to be rounded numbers, maybe it is a little OCD, who knows, but I like purchasing my stocks in increments of 5. A byproduct of dividend reinvestment are additional fractional shares accumulated over time. These additional shares can complicate tax considerations over time as short and long positions become part of your holdings. In addition, determining your cost basis can become much more complicated due to reinvestment. Many brokerage platforms now offer software capabilities that will automatically calculate all of this for you, however, if you are like me and like to double-check the work of software, this can become a very time-consuming activity come tax time.

 

Limited Diversification

 

One worry by many investors is diversification of their portfolio, both among specific holdings, as well as industries. Through dividend reinvestment it is possible that initial diversification can be morphed into concentrated investments over time. The higher yield stocks will typically have more shares purchased and concentrate the investment in their particular industries. Of course portfolios can be rebalanced through additional purchases with fresh capital over time, which is exactly what may also be required even without dividend reinvestment.

 

What are my thoughts?

 

As you may have been able to surmise after reading this article, I am not in favor of traditional DRIP investing. I believe that you can achieve all the positives of DRIP investing by simply pooling your dividends, along with fresh capital and purchasing new securities (or additional shares of current holdings). This of course means that you will be incurring trading fees on your dividends, however, you were going to spend this $7.95 on a new purchase with fresh capital whether you include the dividends in it or not, so really all this does is allows you to accumulate your cash pile more quickly.

 

The most important part of all of this is that I am in full control of the price points and valuations of the new purchases I make. I am still reinvesting my dividends and I am still receiving the immense power of compounding into my portfolio, so little is lost there.

 

What are your thoughts? Are you DRIP investing in the traditional sense? Or are you following a similar strategy as me? Or are you already using dividends to fund your living expenses??

 

 

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