DRIP Question From a Reader

I recently received a question from one of The Dividend Guy’s readers. Let’s call him William (my son’s name) to preserve his identity. Here’s the email he sent me:

“I have an investing topic that I hope you can shed some light on. I’m what you
might call a “catch up” investor. In other words I’m trying to Catch Up!
And I realize I don’t have any bond exposure yet and that’s coming.

Currently…
1.       I have an employer 403(b) set to 33% deduction into domestic stock index
funds, least expensive option.

2.      I have a Roth IRA through Vanguard with an international stock index fund, fully funded.

3.      I’m assembling a small blue chip DRIP portfolio that I hope will generate
dividend income 20 years or so down the line, PFE, PEP, LMT, PG…about $50 a
month for each.

While chatting with folks on investing message boards I’ve had a few remarks
that adding the small DRIP portfolio makes no sense or is redundant. Some have
said that if I have the extra money that I’d be better served increasing the
403(b) deduction even further due to the tax benefits. Please let me know if you get a gut level feeling about this either way.”

So if I resume William’s question: Are DRIPs beneficial for all individuals?

As with any investing questions, there are both short and long answers. The short answer is: it depends . So if we want to know if a DRIP is a good investment strategy we need to look at the long answer. But before we start, if you are not familiar with DRIPs, I suggest you read this article about What is a DRIP and how to setup a DRIP before you go any further in this article.

Now, let’s take a look at the Advantages of a Dividend Reinvestment Plan (DRIP):

#1 DRIPs allow the investor to invest in his holding without incurring transactional costs

#2 DRIPs also enable an “auto-pilot” investment strategy as all cash distributed by the companies are automatically reinvested.

#3 Due to this auto-pilot mode, DRIPs avoid having cash sleeping in your investment account for a long period of time.

However,  using DRIPs is not an investing strategy; it is an additional investing tool

Actually, if you are trying to build a portfolio, DRIPs won’t allow you to invest according to your asset allocation. In fact, DRIPs will only reinforce the positions in stocks you already hold. If you hold a few stocks in your portfolio, I don’t think that using DRIPs is a good investment strategy at first. You should rather take your dividend payouts and accumulate them to buy different stocks.

Now, let’s go back to William’s case:

He has the option to contribute to a tax sheltered investment account supplied by his employer. While he won’t be able to manage his own stocks, index fund investing can work fine considering the following 2 points:

#1 His investments are growing tax free

#2 Chances are that the employer is contributing to his plan (= free money)

Therefore, in William’s case, the question is not really if a DRIP is good for him or not but rather if he has other investment options. He does. Personally, I think you are always better maximizing tax sheltered or employer sponsored investment plans. The tax advantage is very important as well as the “free money” received from his employer.

If William has already maximized his contribution to this plan, I think that using DRIPs would be a great complement to his overall retirement portfolio. What do you think?

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