Earlier this month I discussed how to start a dividend reinvestment plan (DRIP). In that article, I mentioned that DRIP investors who are persistent and develop a good investment strategy can amass a great deal of wealth. This article will focus on the most common DRIP investment strategies and their Pros and Cons.
Lump Sum Investing
A lump sum investment into a DRIP is a method that is very commonly used by investors who have come into a windfall or who are rolling over a retirement plan. The rationale behind this method of investing is that if you think you have discovered a winning stock make a big bet and go for broke. By investing a lump sum, you immediately gain exposure to the stock and its potential gains. The advantage of this method is that you only pay one fee and if the stock appreciates you will come out ahead of the game.
The problem with lump sum investing is that it does not allow for subsequent investments. Also, it does not minimize risk in the eventof a market downturn, or go give investors the benefit of stock diversification. Still a recent Vanguard report concluded that Lump-sum investing outperforms dollar-cost averaging two-thirds of the time.
Dollar Cost Averaging
The most common method of investing for DRIP investors is Dollar Cost Averaging (DCA). This method of investing is often utilized by investors who are unable or unwilling to make a large lump sum investment. Investors who use the Dollar Cost Averaging method of investing make periodic (usually monthly) investments into stocks in their DRIP portfolio. The rationale behind this method of investing is that due to the nature of our markets, stocks will trade in ranges, offering opportunities to buy them at an optimal price. Generally DCA investors buy more shares of stocks when their prices are at the low end of their trading range and fewer when they are at high end. The downside to this method of buying stocks is that over time it is better to be invested in the stock market than in cash. Also, you will not get the full benefit from stocks that appreciate at a rapid rate.
Related: Dividend Reinvestment Plans (DRIPS) & Their Benefits
Stock Diversification
Stock diversification means investing across different companies, sectors and geographic locations that will react differently to world and stock market events. Through diversification investors can reduce risks by not being locked into the performance of a single stock or sector of the stock market.
It is relatively easy to build a diversified DRIP portfolio as there are over 1600 companies that have DRIP’s. While most investment professionals advise their clients to diversify, there are some that advise against it. They reason being that by diversifying investor’s water down their portfolio and cannot realize the full benefit of their top performing stocks.
Investing In Companies with the Highest Dividend Growth Rates
Some investors invest in companies that have the fastest growing dividends. In 2012, the 50 fastest dividend growth companies had an average dividend growth rate of 56.7%. The rationale behind this method of investing is that dividend growth is often a good indicator of a company’s financial health. If a company is able to consistently increase its dividend, then it is logical to believe that it has strong positive cash flow and a rosy future. However, investors need to be careful and exercise due diligence before investing in companies just because they have high dividend growth rates. It is important to make sure that the company has the earnings and the positive cash flow to maintain its dividend payments. It is also important to evaluate whether the stock has the potential to appreciate in value.
Related: How to screen and pick solid dividend paying stocks for the long run
Dividend Aristocrats
Those that utilize the dividend aristocrat, invest only in companies that have been classified as Dividend Aristocrats. Two of the requirements for a company to be classified as a Dividend Aristocrat are that it must be a member of the S&P 500, and it must have increased dividends every year for at least 25 consecutive years. The stocks of Dividend Aristocrats are attractive because they are issued by mature companies that have strong positive cash flow, and as of March 31, 2012 Dividend Aristocrats beat the S&P 500 Index over the last 1, 3, 5, 10, 15, and 20-year periods. The drawback to the Dividend Aristocrat method of investing is that it limits investors to only the stocks in the S&P 500, thus limiting an investor’s choices and opportunities. [Also see: Top 5 Dividend Aristocrats and 2013 Dividend Aristocrats]
Conclusion
Developing a DRIP can be a great way for investors to safely invest in stocks. When developing a DRIP, investors need to carefully consider their investment objectives before deciding on an investment method. The five methods that are discussed in this article are the most common methods of DRIP investing, and they should each be considered by any investor that wants to develop a DRIP.
Darnell Brown is an accountant with over 20 years of auditing experience. He has worked in both the private sector and for the United States Government. He currently works as a freelance writer and has written numerous financial articles for the investmentunderground.com website.