Why You Should Never Automatically Reinvest Dividends
When you enroll in DRIPs, you violate your fiduciary duty to yourself
Dividend reinvestment programs (DRIPs) are a cornerstone of modern personal finance. Conventional wisdom says they are a no-brainer, something that all savvy investors should enroll in. However, you should not enroll in dividend reinvestment programs- because there is a better way to reinvest your dividends.
DRIPs started in the 1980's and really took off in the 1990's. The original purpose of DRIP programs was to beat the significant stock trading commissions that prevailed at the time. In those days, stock trading commissions were high and ease of market access was low.
Back then, investors were charged commissions that would seem jaw-droppingly high today. Commissions were charged as a percentage of the total trade value. For example, if you wanted to trade 100 shares of a stock trading at $20, the total trade value would be $2,000. Your broker might charge you a 5% commission, or $100, for both the buying and selling of this block of stock. That's a lot of money (especially in 1980s dollars!)
If you wanted to trade a smaller lot of shares (such as reinvesting a modest amount of dividend income) a flat minimum fee may be charged- perhaps $25 or $50 per trade. Again, this was a sky-high amount.
In that environment, it often did not make sense to reinvest dividends. If you received a smattering of dividend income, and had to pay a third or half of it as stock trading commissions, it just wasn't worth it.
In the 1990's, stock commissions were falling thanks to online trading, down to $8.95 per trade. But that amount was still high as a percentage of total trade value. If you received $50 or $100 in dividend income, paying $8.95 to reinvest it was not a great bargain. In those days, dividend reinvestment programs made a lot of sense!
Today, of course, stock trading commissions are "free." (They are not really free- brokerages still recoup that expense in the form of wider bid-ask spreads, payment for order flow, and the usual Wall Street sleight of hand.) Despite this, dividend reinvestment programs are a bad idea. They are a bad idea for one simple reason: they violate the fiduciary duty that you, as an investor, owes to yourself and your portfolio.
All investment is based on valuation. A good company with a too-high stock price is a bad investment. And a stock that has declined in price may be doing so for a reason- one that you need to pay attention to. The most successful investment styles of the postwar era, as espoused by Warren Buffett, Graham and Dodd, and others, all focus on valuation. They acknowledge that money is made when you buy a stock- not when you sell.
Placing your investments on auto-pilot violates this fiduciary duty that you owe to yourself. It puts you in the category of "dumb money" that will invest no matter what.
A Better Approach
A better way to reinvest your dividends is to always have your #1 investment idea ready to go. This stock idea takes into account changing market conditions and new opportunities. When you receive dividends, you will reinvest them into this name- your best idea at the time.
(Unfortunately Wall Street has not yet invented a platform to implement this automatically- to instruct that all cash dividends will be automatically invested into a single stock of your choosing. But they probably will soon.)
You can also give yourself some flexibility by keeping your "best idea" to 2 or 3 names. You can think about these names during your down time during the day- when you are driving to work, or waiting at the doctor's office. Ask yourself "If I were to be given $100 today, where would I invest it?"
Reinvesting your hard-earned dividends into your current best idea, rather than your older best ideas, helps you avoid the cardinal sin of investing: overpaying for stock. You can incorporate this "best idea sweep" into your financial housekeeping routine and do it on that day of the month when you sit down to pay your bills.
Of course, your current best idea may be the same as your old best idea. You may wish to reinvest your hard earned dividends into a stock that you currently own. But with this strategy it will be you making those decisions- not an automated program.