As a dividend investor, it is usually assumed that I love dividend reinvestment plans (DRIPs). Truth is that I think they are a great thing to use to save investment costs. However, I have met a lot of investors who believe that the use of a DRIP is an investment strategy in itself as opposed to the means to an end that it is. Let me explain.[ad#tdg-embedded]
What is a DRIP
A DRIP is a plan offered by a company whereby a shareholder registers his/her share ownership directly with that company so that additional shares or fractional shares can be purchased when the company pays that dividend. The best part is that many DRIP plans allow investors to reinvest their dividend into more shares commission free and sometime at a discount to the current share price. It can be a very good way to grow an investment portfolio over a long period of time.
The Wrong Way to Use DRIPs
My issue is not with DRIPs as a way to build a portfolio. My issue is with how many investors use DRIPs. I have many friends who use DRIPs and have built a portfolio around those DRIPs. In the last market correction they got creamed. Not because of the fact that they were in the DRIPs, but because they had a poorly planned portfolio that was not built around sound asset allocation principles and therefore not at all diversified. They were so focused on building up a portfolio of DRIPs that they ignored more fundamental aspects of building a portfolio.
When I probe them about their portfolio, it was clear that many of their investment decisions were based on the fact that the holdings in their portfolio offered DRIPs and therefore they bought that stock. Some of these people did do good due diligence around the company and made their investment decisions with that information, but they also invested in that company because they offered a DRIP. As a result, they had portfolios that were concentrated in banks and in certain industries as opposed to across industries and with enough different companies to offer adequate diversification.
DRIPs can be a good way to build a portfolio. The low fees and opportunity to buy shares at a discount can be very appealing. However, it is more important to ensure that you have a balanced portfolio that is constructed with an asset allocation that is appropriate for you.
With that asset allocation in mind, an investor then needs to determine the best way to fill in that portfolio with quality assets. Industry and sector decisions should be determined. Only then should actual companies be considered and I like to look for the best companies in that industry and sector. If the chosen company(s) offer DRIPs, then take advantage of that. However, be sure that you are making the decision based on the merits of the company and not just because it offers a DRIP.