One of the most valuable aspects of DRP investing is something that may surprise you.
DRP investors do better than those using traditional brokerages because they are less involved in the day-to-day movements in the market. In other words, they tend to outperform their peers simply because it’s more difficult to trade through a DRP and, therefore, they are less likely to buy or sell at the wrong time.
After watching the market for the past 50 years, we are convinced that that is true.
Instead, DRP investors establish a diversified portfolio and follow a predetermined strategy to build their positions over 10, 20, or even 50 or 60 years.
This is a tried and true strategy. It’s simple and it works but you must pick the right companies.
Two critical factors to keep in mind:
Diversifying among market sectors is an uncontested risk-reducing strategy. Diversifying holdings within a traditional brokerage account, where you generally buy in 100 share lots, is more limiting than diversifying among DRP companies, where a small dollar amount is all you need to open an account (or, you can open an account as a shareholder by owning as little as a single share of company stock in your own name–not in a brokerage account name).
Before you buy your first DRIP stock:
Calculate how much you can afford to put away for stock investing each year. With that information in mind, you can decide how many companies you should own in your portfolio. The minimum investment amount accepted by most companies is $25 or $50. Once you know your budget for the year, you can decide how many companies, how much you will invest in each, and how often. If you are investing over the long-term, you are likely to be buying at different price points. If you are routinely investing the same amount of money, you will be buying more shares when the price is low and fewer shares when the price is high!
But what should you look for in a company before you become an owner?
You may think that creating and maintaining a diversified stock portfolio is a daunting task—-one that’s better left to the professionals. But the truth is that you can minimize risk, build a stock portfolio, and cut costs by doing it yourself.
The importance of an easy to implement strategy cannot be over-emphasized. You won’t benefit by being tossed about by the winds.
Investing can trigger emotional reactions that lead to mistakes, so your most valuable assets are patience—-and time. Investing is a long-term—-even lifetime—-pursuit.
Picking stocks
“Don’t put all your eggs in one basket” is the conventional wisdom, and its good advice. When some of your stocks are lagging, others may be gaining. This way, you won’t feel pressure to sell the laggards. In fact, if a company’s fundamental strength hasn’t changed, you would want to be buying its shares when they are lagging, not selling them.
Unfortunately, many people are intimidated by the prospect of choosing five or 10 stocks—to say nothing of 20 or 30, to set up a well-balanced portfolio. That’s why so many opt for owning a mutual fund and abdicating the responsibility. But mutual funds have their drawbacks. Some charge high fees, perform poorly and have a short-term focus. Worse, they may saddle their investors with unwanted taxable capital gains distributions that can occur even when the fund is down. And investors may be clueless about the companies owned by the fund.
But, if you are reluctant to choose your own stocks, at drp.com we offer four starter portfolios with five companies each to give you an idea of how to get started. When you have gained more confidence, you can begin choosing your own companies.
How many stocks should you own?
A 20-stock portfolio probably provides sufficient diversification to minimize investment risk, but it is up to you to decide how much diversification is appropriate given your financial circumstances. For the mutual fund we manage DRIPX, we determined that a 63-company portfolio is sufficient to ensure that a drastic misfortune affecting any one company will have minimal impact on the entire portfolio. That portfolio is specifically geared for retirement purposes, so we are super—-conservative.
When deciding on the number of companies in your portfolio, keep in mind that it does not pay to open a DRP account if you cannot afford to fund it with subsequent investments. It’s better to start with five companies and add additional diversification when the dividends from the five initial companies pay is sufficient to provide for continuing investments. Then add companies as you can afford to support with subsequent investments.
Your Holdings. . .
Picking long term holdings.
A useful gauge of a company’s long-term value involves the dividend it pays to shareholders. Interestingly, DRPs were first organized as Dividend Reinvestment Plans, which may account for their over performance compared with the market as whole. [As proof of their superior returns: In January 1994, Moneypaper editors created a DRP stock index to compare the performance of a representative group of 63 DRIP stocks with the other market Indexes. The DRP Stock Index over performed all the others and by substantial amounts (and became the basis for our now Morningstar Gold Medal mutual fund, the MP63 Fund (DRIPX), which we created in 1999 for subscribers who wanted to invest their IRAs in DRP stocks (and needed a custodian in order to do that).]
You don’t necessarily want to look for the company that provides the largest yield. That yield may result from a drop in the stock price (which is something you’d want to look into and evaluate). Instead, look at the amount of the dividend to see whether it can comfortably be paid out of the amount of earnings the company reports. That’s the payout ratio. And take into consideration the anticipated earnings for the next year and whether any trend in earnings is evident.
Another consideration is whether the company is consistently raising the dividend amount. The fact that a company has been able to grow the amount of the dividend over the years, is likely an indication that management is both considerate of its shareholders and doing a good job. What’s more, if the company has a track record for increasing its dividend, it is likely to continue to do so.
At Drp.com there’s information about every stock available from the universe of over 400 companies that offer DRPs. You can identify the stocks with the characteristics that you may be looking for. For instance, you can request a list of DRP companies with yields of 3% or more. You can narrow your search to those in a certain sector and/or to those with a certain quality ranking or better—and/or to those that don’t charge fees while meeting your other criteria and more.
Rather than risking several thousand dollars at once, you can order that small amounts be auto debited from your checking account or you can write out checks in advance. Combine this idea with the concept of owning a handful of basic industries—-such as food, banking, energy, utilities, and health care—-and building a portfolio, based on starting with as little as a single share, and building up holdings over the long term becomes manageable–even easy and enjoyable.
Making choices
After you identify familiar companies in the five basic industries, determine which competitor in each industry represents the best investment. Remember that you’re focusing on the long term, not trying to “bet” on a company that may surge over the next weeks or months.
You should also rely on your own common sense. Companies that are laden with debt will have a hard time growing profits, just as individuals with hefty credit card balances have a hard time saving money. (Certain industries are exceptions. For instance, utilities must borrow heavily to build new power plants, and banks’ liabilities are high because they include depositors’ money.)
Debt-laden companies must devote much of their operating profits to interest expense and, therefore, are hurt more than debt-free companies when interest rates rise. But even interest rates rise and drop and those patient long-term investors can wait out several are destined to accumulate wealth.
Another basic yardstick is a company’s price/earnings (or P/E) ratio (the stock’s price divided by earnings per share). By calculating a stock’s P/E, you can easily compare it with other companies in its industry to see if it represents a good value. Unloved stocks will have lower P/Es than ones that are enjoying great popularity. But lovers are fickle, and you can make your own judgement about a company’s future prospects.
Value versus growth
Companies are typically classified as “growth” or “value” stocks. Growth stocks increase revenues and earnings at an above-average rate but pay little or nothing in dividends. By contrast, value stocks typically have slower—-albeit steady and reliable—-growth and pay more in dividends. As a growth stock (and its industry) matures, its rate of growth may slow, so it may reward shareholders by increasing its dividend.
It’s best to own a mix of growth and value stocks because they tend to take turns leading the market. For instance, in the late 1990s, growth stocks were in vogue, with very high P/Es, causing some experts to warn that even the slightest corporate misstep could cause the stocks to decline. Value stocks were out of favor, as evidenced by their relatively low P/Es and higher yields. (Yields in general had declined for both groups, partly as a result of more favorable tax treatment for capital gains, compared with dividends.) But, after the bear market of 2000-2002, value stocks rebounded more quickly than growth stocks.
Investing for the future
Investing for the next several decades requires two commitments: getting started now and adding to your nest egg regularly over the years. Many people give in to the inertia of indecision and a feeling of helplessness, so they simply don’t get started. But as we’ve said, you are the best analyst you can find. Considering the track record of many mutual funds and market “gurus,” you’re likely to do at least as well as any “expert.”
Buying the first share in order to enroll in a DRIP should kick-start your investing experience. Once you have a DRP statement (and the tear-off portion for additional investments) in hand, it’s easy to get going. Hundreds of companies even let you set up automatic debits from a bank account, so there’s no excuse—-even for the person who hates to write checks…for delaying the accumulation of wealth to meet your long-term goals.
If you have very little to start with, you can begin with one DRIP and add others periodically until you have a diversified portfolio. Otherwise, starting with a handful of basic industries and adding others later will do the trick.