One of the most common questions on the boards revolves around how to get started with Drips. When I first heard of the Drip concept, things didn't really click in my mind, so it is easy for me to understand the difficulty some might have with the strategy.
Unfortunately, the proper answer to this question is more involved than a few sentences might be able to offer. For this reason, I decided to go through the life of a Drip, from the initial thought process through the decision to sell. Obviously, this will be spread over the next several weeks.
We begin with a quick definition of a Drip, so that we understand the complexity of working with this simple strategy. Drip, or commonly written as DRiP, is the acronym for Dividend Reinvestment Plan. This is a program offered by many companies whereby an individual may purchase stock from the company's transfer agent, as opposed to doing so through a broker. As some companies do not offer such a plan, a few brokers have offered what I refer to as a Pseudo-Drip. This has nothing to do with a Drip (thus the terminology), but is similar in the respect that the broker allows for the purchase of partial shares at a small cost. Both plans allow for the reinvestment of dividends typically without charge.
The strength of this strategy lies in dollar-cost averaging, where one makes numerous purchases over a long period of time. This reduces risk, which is an important aspect of investing.
Before jumping in head first, the individual needs to decide that this strategy is a proper means of investing for them. It would be reasonable to assume that the strategy would be ideal for everyone, but this really is not the case, as there are situations for weakness in the strategy. Although there are ways to work around each, the limitations need to be understood.
All Drip plans have minimum purchase amounts. This does not mean that one is required to purchase every month, but when purchases are made, the amount must be at least this amount. Though this amount, for some companies, is as little as $10 (Coca-Cola, for instance), others can be as high as $100 (Mellon Financial is an example).
Often, the immediate answer is to save one's money over the course of several months until you can afford to make the minimum purchase. Although this can be done, the downside is that doing so increases risk, as we saw in the article Blind Dollar Cost Averaging. If you are unable to make regular purchases because of a high minimum purchase amount, you need to understand the extent to which you are compromising the strength of this strategy.
Yes, there are maximum amounts too, but they will seldom apply (Coke's maximum is $60,000 per year and Mellon's is $100,000 per year). I hope this to be a limiting factor for me some day.
Another consideration is the discipline required for one to invest regularly. The number of people deep in credit card debt is an example of this lack of discipline.
If you do not feel you have the required control to invest regularly, then you can establish an Automated Clearing House (ACH) with the transfer agent. Most transfer agents allow for the automatic transfer of purchase money from one's bank account, though there may be a charge for this despite the offering of a fee-free Drip. Although the cost of transferring money is less than opening an envelope with a check in it, some companies invoke this charge as a means of defraying the cost of administering the Drip.
Finally, one must consider the timeframe under which they are working. Drips generally tend to work best when established over a decade or longer. If you need your money within a shorter period of time, then Drips may not be the best vehicle.
The consideration for this, once again, returns to the aspect of risk. The shorter the timeframe, the greater the risk, though the risk might be worthwhile. For instance, some may assume that Drips would not be a prudent route for the recently retired. However, with people living well into their 90s not being uncommon, I would think that the consideration of moving some funds from a non-moving cash account to a risk-lessened securities strategy would be prudent.
Assuming one has decided that Drip investing is proper, the next step is to buy some companies, right? Not yet. We'll go to the next step next week, and it has little to do with making a purchase.
To discuss this column or pose a question, please visit us on the Drip Beginners board linked below.
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