Friday, April 3, 2015

To DRIP or Not to DRIP

Many companies and brokers offer dividend reinvestment plans (DRIP) to reinvest any dividend paid in the same stock at the prevailing market price, in lieu of dividends being paid in cash. DRIP has numerous pros and cons. The choice is one of individual preference.

1. Immediate deployment of cash into accumulating more shares minimizes cash drag. Any dividend paid out is immediately used to buy more stock, which over the long term has a much greater expected return than cash.
2. Dollar cost averaging over time helps investor to buy more stock at lower prices and less stock at higher prices.
3.  No time is needed to decide how to reinvest the dividends paid out. The time saved can be used to pursue other endeavors.
4. DRIP allows money to stay in the same stock to build up a larger position gradually.

1. There is no control over the market price at which dividends are reinvested. A stock may be grossly overpriced at the time of dividend reinvestment, giving investor a lower expected return for the cash.
2. More attractive investment options may be available than reinvestment of cash dividends in the same stock.
3. Theoretically, companies pay out in dividends earnings that they cannot reinvest within the business to obtain a higher return than the cost of capital. They are essentially telling investors to take the cash and reinvest it elsewhere for higher return. This is more true of higher dividend payers. DRIP runs counter to this theory and leads to putting more money into higher dividend yielding stocks of companies that have little growth potential.
4. The burden of record-keeping increases proportionately with the number of different stocks in your portfolio. DRIP in a dozen stocks is manageable, but DRIP in 100+ stocks can become an accounting headache.

I had been using DRIP to reinvest all my dividends for many years, both in my direct share purchase plans (DSPPs) and in my two major brokerage accounts. Gradually, the number of holdings in my brokerage accounts have increased, and the burden of record-keeping started to weigh in on me. Last month, Con #4 finally tip the balance over and I decided to stop DRIP in my brokerage accounts.

As for my DSPPs, I will continue to use DRIP because the pros outweigh the cons. I don't have too many DSPPs, so the paperwork is manageable. The stocks in my DSPPs also tend to be higher in quality compared to those in my brokerage accounts, so I am more inclined to accumulate more over time and less sensitive to the price I pay.

Con #1 and 2 becomes less significant the longer one's investment horizon, but only in high quality stocks that can be bought and held indefinitely. Price is obviously critical for cigar butts. In general, I would say that DRIP is a bad idea mainly because of Con #3. Investors who do not need the income should invest mainly in low yielding stocks with high expected growth. Those who do need the income can ill afford to DRIP; rather, they should spend the cash and reinvest only any surplus left.

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