Regular readers know I’m a big fan of DRIPs (dividend reinvestment plans) for many reasons (see any of the posts in my sidebar, but especially How To Invest Commission-Free). But recently I’ve be rethinking some of my DRIP strategy. In the past I’ve been 100% reinvested, but the recent economic environment has me getting more proactive and critical of full reinvestment as a strategy. Here’s why.
100% reinvestment works best in a strong earnings growth environment. We are not in that environment right now, not even in Canada. When companies grow their earnings and want to keep the same payout ratio, they will increase their dividends and will not need to issue more shares. Hence your growing dividends will eventually be able to buy more shares than they were previously. Indeed, ideally, even your rate of “purchasability” would grow.
In a negative growth environment, your reinvestments might not only not be able to keep their purchasing power, but past gains can also be wiped out. As a case in point just look at what happened to Enervest Diversified Investment Trust (EIT.UN) over the past year. You may have been able to buy more units with each distribution, but this rapidly declined as their unit price fell, they cut the distribution, and then bought back shares.
Simply put, 100% reinvestment means you’re not diversified. It means your investment’s value is at the whim of the company’s decision on not only their distribution or dividend amounts, but also the amount of shares outstanding. It means, effectively, that you assume a very bullish position on that company’s future growth.
It may be free; it may get you a discount on the stock, but 100% full reinvestment is not a fail-safe strategy for growth. It can put your investment on a risky foundation, too.
Recommendation For DRIP Cashflow Diversification
Consider periodically withdrawing some shares from the DRIP plan and depositing them into your broker, so that you can receive some of the dividends in cash. While these dividends will not be automatically reinvested and you will have to actively manage them, the advantage here is that you can now redeploy the dividends according to what the current economic environment dictates.
(1) If it becomes obvious that deflation is hitting hard, you can use these to pay off debt and solidify your returns.
(2) If inflation is hitting really bad, you can use this cash to buy good yield and invest in interest-bearing vehicles.
(3) And you can always use it to reinvest back into a chosen DRIP — again, depending on which company has the best growth prospects at the time.
The overall point is that you need to remain flexible with your investment strategy in changing economic environments. As part of overall portfolio rebalancing, pay attention to your cash flows, not just total market values. Different economic periods require and suggest different cashflow strategies. If you were to simply remain fully reinvested and let your portfolio sit on automatic, then yes, theoretically your 20-yr returns might be boosted through greater leverage, but the stock’s performance could also wipe out significant value that might otherwise have been more usefully redirected to removing debt and building the low-risk savings side of your portfolio.
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DRIPs were really important in the 1980s, when transaction costs could easily eat up a huge fraction of your investable cash. Once on-line brokers pushed commissions to the $10 range, though, I think the commission-free aspect of DRIPs made a less compelling story.
The other thing that DRIPs provided was a certain kind of discipline–the dividends got reinvested in stocks whether you thought the market was going up or down. If your natural inclination was to sit on cash waiting for a “good buying opportunity,” this sort of discipline stood you in good stead from the early 1980s through the mid 2000s.
Personally, I turned off my last DRIP a couple years ago. Dividends go into my brokerage account, and I invest them, not in the company they came from, but in whatever seems like the best investment at the moment.
@Philip – totally agree on your last point, this is more the direction I’m headed in. I’ll still keep my DRIPs open for the free share purchases, though. In Canada, sadly, the majority of commission fees are still very high ($29!) unless you have $100k in the account or do a high volume (or certain #) of trades each month. There are some brokers with nominal commissions of $9.95 etc., but the last time I checked, there were other drawbacks to using them (eg., I think you had to keep a certain level of cash just idling in the account, which I didn’t want to do).
I always enjoy articles about DRIP’s :)
However I don’t quite understand your point about “Simply put, 100% reinvestment means you’re not diversified”.
Of course I’m assuming you already have a well-diversified portfolio to begin with, so whatever dividends you receive, will just be placed back into the respective company, which will maintain your diversification. It may get un-balanced, but I always do a re-balance once a year to off-set that.
I can understand the argument if you’re only dripping a few companies, but for someone like me, who is dripping 12 companies, I feel that the “diversification” aspect seems moot.
@SW – right. I would assume one would already be diversified across different companies. I guess the type of diversification I’m referring to, then, is slightly different – a diversification based on market outlook or risk? I’m not sure what to call it. If you’re also dollar cost averaging, you’re diversified over time. I too also have more than a dozen DRIPs, so I know where you’re coming from. Like I said, this is a recent revelation to me and previously I would never have given it much thought.
Enervest is a closed-end mutual fund so I do think it’s a good example. No-fee investing in equities (and some trusts) is optimal when the company regularly increases is diividend (or distribution). So some research is required. Just because a company offers a DRIP doesn’t mean it makes it a good investment.
@Jon202 – I agree, just because it has a DRIP doesn’t guarantee any quality of the investment, you still need to evaluate the company on its own terms. I have cancelled a few of my DRIPs for this reason.
I think DRIPs are a neat idea but like Philip said – not necessarily all that useful.
As for cheap trades in Canada – I use Questrade which has $5 trades. You only need $1000 to start an account and must maintain a minimum balance of only $250.
Hey MoneyEnergy,
I hope you had (are having) a good holiday!
Question: Do you pay any fees for withdrawing shares from DRIPs with CIBC Mellon or Computershare? I don’t mean selling shares, but withdrawing the shares from the DRIP, and then, depositing those shares into my brokerage account; such as TD Waterhouse?
You wrote above, about withdrawing some shares from the DRIP and depositing them into your brokerage account, periodically I assume, to receive some of the dividends in cash. This seems like a good idea once you have >$100,000 and say 5 or 6 DRIPs running…and you can afford to keep the DRIPs running, but also take some of the cash and redeploy it where you wish.
I am also assuming, as long as you don’t sell the shares, you don’t pay capital gains?
Thanks!
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