Dividends - DRIP, Hold, or Do Nothing?

10 Aug 2013 13:57

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As a new investor you may be asked by your brokerage if you wish to enroll in a free dividend re-investment program or as it is often referred to as DRIP investing.

A DRIP program is very simple in its nature, when a company issues you a dividend payment your brokerage account will automatically take that payment and buy additional shares of the same company. This concept is often referred to as compounding. Compounding in itself is a powerful savings tool but is it right for your portfolio?

Compounding works best when your investment vehicle has a consistent price. With a money market, savings account or bank C.D. this works very easy. Each unit is valued at $1 so when you reinvest the investment value is always constant at a purchase price of $1.

Dividend yield for stocks are much different. Stock dividend yields are calculated as the dividend payout divided by the price of the stock. Since stock prices are changing daily the dividend yield will fluctuate, the higher the stock price the lower the dividend. When stock prices increase faster than dividend payouts you begin to lose some of your growth momentum and DRIP programs actually hold back your portfolio from peak growth performance as they may be buying when stock price is rapidly increasing. A strategy common among dividend growth investors is to let your dividend payments accumulate and invest when a growth value opportunity presents itself.

Does this mean that DRIP investing has no place in your portfolio? Absolutely not, there are some stock investments where a DRIP works wonderfully if they have what is referred to as a low Beta. Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are scored according to how much their stock price goes up or down in comparison to the market. A stock with small price swings has a low beta (less than 1) and wild price swings have a high beta (greater than 1). Companies that have a beta less than 0.4 typically make for very good DRIP programs. Examples of companies that sport a low Beta are usually utility companies.

So that leaves two reinvestment strategies:

  1. DRIP for companies with a Beta that is less than 0.4
  2. Hold & accumulate for buying opportunities for companies with a Beta greater 0.4

Another topic new investors need to be aware of is whether there is a time when not to reinvest dividends. There are times when you should not reinvest and it will vary by person so I will attempt to address a few:

  • 10% of your portfolio is not in cash – Having a 10% position in cash offers you two significant advantages. First it gives you capital to take advantage of opportunities with a significant position. Second, it provides risk relief in falling markets.
  • Your retired – Dividend payouts may be required to replace income by supplementing Social Security payments.
  • Unemployed – This is similar to being retired where you attempt to replace income loss by supplementing unemployment benefits with your dividend income stream. With a little luck this may hold you over until you get a new job and prevent you from selling any portfolio assets.

I have heard some folks not re-investing on a hunch (or fear) that a stock market crash is imminent. This is often referred to as market timing which is something few people ever get right (including professional investors). My advice is to not worry about market timing and instead focus on your portfolio growth while balancing it for risk through diversification and maintaining a 10% cash balance.

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