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Overview

In reading the comment sections of many articles associated with Dividend Growth Investing, one question repeatedly pops up as to whether it is better to DRIP dividend payments back into companies or to collect dividends as they come in and then direct the investment into a lagging stock in the portfolio to rebalance positions.

A DRIP, or dividend reinvestment plan, in the traditional sense is a plan offered by a corporation allowing investors to reinvest their cash dividends by purchasing additional shares or fractional shares on the dividend payment date. While some corporations still offer DRIP plans, the advent of online investing has shifted most investors towards brokerages, of which the majority will allow dividends to be reinvested without a transaction fee. Participating in a DRIP is a more passive way of investing as the investor does up front research to choose which dividend paying company to invest in, and then letting the magic of compounding interest do the rest of the work after that. The investor would continue to monitor their positions to make sure that the underlying fundamentals of the company are still intact and, if nothing changes fundamentally, they let dividend growth and compounding reinvestment grow the position.

With a rebalancing directed reinvestment if a person was not contributing cash into the account on a monthly basis they could collect dividends from holdings and allow the cash balance to accumulate to $500 or $1,000. This money is then used to either add to a stock in the portfolio to bring it into balance with the rest of the holdings or add a new position in a stock to further diversify. The idea is that by controlling where the investments are made a portfolio manager can buy on the dips rather than by chance adding to a position at 52 week highs in a DRIP.

The third option is to withdraw cash from the account as dividends are paid and use them as needed for everyday life. This is generally done by retirees when they shift from the accumulation phase to the income phase of dividend investing and the cash flow is used for living expenses during retirement.

Portfolio Assumptions

As a newcomer to managing my 401k I wanted to do some research into the different methods and hopefully determine what option is best for me as I build my nest egg and prepare for my future retirement. I decided to select four stocks from my current retirement portfolio, all of which are members of David Fish's Dividend Champions list, and do a twenty five year back test to see which method provides the greatest returns. I selected a twenty five year period to make ensure that trends were established and also because I hope to retire in approximately twenty five years from now and wanted a realistic experiment.

For this exercise I selected Aflac Inc. (AFL), The Clorox Company (CLX), McDonald's Corp. (MCD) and Target Corp. (TGT). A $1,000 position was started in each company on January 4, 1988. The historical stock price and dividend information was found on Yahoo Finance and an Xcel spreadsheet was set up for each position to calculate returns and track reinvestments.

DRIP reinvestments were made using the ex-div date provided by Yahoo, with the purchase price for reinvestment being the opening price on that date. Rebalance purchases were made when collected dividends exceeded $500 in value and purchases were made using the opening price of the stock that had the lowest total value in the portfolio on the final day of trading for the year.

Results

Here are the initial positions established for the portfolio.

Begin Portfolio (January 4, 1988)

Company (Ticker)

Shares

Price

Value

Aflac

83

$ 12.05

$ 1,000.15

Clorox

36

$ 27.75

$ 999.00

McDonald's

23

$ 44.00

$ 1,012.00

Target

35

$ 28.50

$ 997.50

Initial Investment:

$ 4,008.65

Here are the results after the first five years:

DRIP (December 31, 1992)
Company (Ticker)SharesPriceValue
Aflac91.068$ 32.06$ 2,919.64
Clorox42.5819$ 46.50$ 1,980.06
McDonald's48.429$ 49.00$ 2,373.02
Target39.0177$ 75.12$ 2,931.01
Year 5 Value:$ 10,203.73
Rebalance (December 31, 1992)
Company (Ticker)SharesPriceValueCash
Aflac83$ 32.06$ 2,660.98$ 206.71
Clorox48$ 46.50$ 2,232.00
McDonald's46$ 49.00$ 2,254.00
Target35$ 75.12$ 2,629.20
Year 5 Value:$ 9,776.18$ 9,982.89
Dividend Withdrawal (December 31, 1992)
Company (Ticker)SharesPriceValueCash Div.Total
Aflac83$ 32.06$ 2,660.98$ 138.61$ 2,799.59
Clorox36$ 46.50$ 1,674.00$ 243.36$ 1,917.36
McDonald's46$ 49.00$ 2,254.00$ 76.80$ 2,330.80
Target35$ 75.12$ 2,629.20$ 224.70$ 2,853.90
Year 5 Value:$ 9,218.18$ 683.47$ 9,901.65

After 5 years, the DRIP portfolio led the way with a total value $221 higher than the Rebalance portfolio and $302 higher than the Withdrawal portfolio. The first transaction in the rebalancing portfolio was made at the end of 1991 with the purchase of 12 shares of Clorox at $41.38.

Here are the 10 year results.

DRIP (December 31, 1997)
Company (Ticker)SharesPriceValue
Aflac181.9804$ 49.88$ 9,077.18
Clorox99.3564$ 80.12$ 7,960.43
McDonald's100.4345$ 47.06$ 4,726.45
Target129.5718$ 68.00$ 8,810.88
Year 10 Value:$ 30,574.95
Rebalance (December 31, 1997)
Company (Ticker)SharesPriceValueCash
Aflac155.625$ 49.88$ 7,762.58$ 304.89
Clorox96$ 80.12$ 7,691.52
McDonald's104$ 47.06$ 4,894.24
Target129$ 68.00$ 8,772.00
Year 10 Value:$ 29,120.34$ 29,425.23
Dividend Withdrawal (December 31, 1997)
Company (Ticker)SharesPriceValueCash Div.Total
Aflac155.625$ 49.88$ 7,762.58$ 406.86$ 8,169.44
Clorox72$ 80.12$ 5,768.64$ 614.52$ 6,383.16
McDonald's92$ 47.06$ 4,329.52$ 198.42$ 4,527.94
Target105$ 68.00$ 7,140.00$ 534.10$ 7,674.10
Year 10 Value:$ 25,000.74$ 1,753.90$ 26,754.64

After 10 years, the DRIP portfolio continued to lead the Rebalance portfolio by $1150 and the Withdrawal portfolio by $3820. Purchases made in the Rebalance portfolio were 8 shares of Target for $70.00 at the end of 1994 and 12 shares of McDonald's for $46.13 at the end of 1996. In looking at the Withdrawal portfolio, after 10 years the companies have paid out a cumulative $1754 in dividends, which is about 44% of the initial investment.

Here are the 15 year results.

DRIP (December 31, 2002)
Company (Ticker)SharesPriceValue
Aflac753.9969$ 30.25$ 22,808.41
Clorox218.2511$ 41.41$ 9,037.78
McDonald's206.3292$ 15.70$ 3,239.37
Target536.6721$ 30.00$ 16,100.16
Year 15 Value:$ 51,185.72
Rebalance (December 31, 2002)
Company (Ticker)SharesPriceValueCash
Aflac622.5$ 30.25$ 18,830.63$ 16.72
Clorox216$ 41.41$ 8,944.56
McDonald's286$ 15.70$ 4,490.20
Target516$ 30.00$ 15,480.00
Year 15 Value:$ 47,745.39$ 47,762.11
Dividend Withdrawal (December 31, 2002)
Company (Ticker)SharesPriceValueCash Div.Total
Aflac622.5$ 30.25$ 18,830.63$ 941.43$ 19,772.06
Clorox144$ 41.41$ 5,963.04$ 1,183.32$ 7,146.36
McDonald's184$ 15.70$ 2,888.80$ 391.07$ 3,279.87
Target420$ 30.00$ 12,600.00$ 975.10$ 13,575.10
Year 15 Value:$ 40,282.47$ 3,490.92$ 43,773.39

After 15 years the DRIP portfolio has widened the gap and now leads the Rebalance portfolio by $3424 and the Withdrawal portfolio by $7412. Purchases made in the Rebalance portfolio during this period were 8 shares of McDonald's for $78.25 at the of 2008, 24 shares of Clorox for $34.44 at the end of 2000 and 62 shares of McDonald's for $15.70 at the end of 2002.

Here are the 20 year results:

DRIP (December 31, 2007)
Company (Ticker)SharesPriceValue
Aflac796.4824$ 62.41$ 49,708.47
Clorox241.8876$ 65.49$ 15,841.22
McDonald's226.1239$ 59.72$ 13,504.12
Target557.2715$ 50.75$ 28,281.53
Year 20 Value:$ 107,335.33
Rebalance (December 31, 2007)
Company (Ticker)SharesPriceValueCash
Aflac622.5$ 62.41$ 38,850.23$ 60.24
Clorox259$ 65.49$ 16,961.91
McDonald's363$ 59.72$ 21,678.36
Target516$ 50.75$ 26,187.00
Year 20 Value:$ 103,677.50$ 103,737.74
Dividend Withdrawal (December 31, 2007)
Company (Ticker)SharesPriceValueCash Div.Total
Aflac622.5$ 62.41$ 38,850.23$ 2,479.00$ 41,329.23
Clorox144$ 65.49$ 9,430.56$ 2,012.76$ 11,443.32
McDonald's184$ 59.72$ 10,988.48$ 1,149.15$ 12,137.63
Target420$ 50.75$ 21,315.00$ 1,764.70$ 23,079.70
Year 20 Value:$ 80,584.27$ 7,405.61$ 87,989.88

After 20 years the DRIP Portfolio continues to lead the way by $3,598 over the Rebalance Portfolio. Purchases made this period in the Rebalance portfolio are 25 shares of McDonald's at $24.84 in 2003, 25 shares of McDonald's for $32.40 in 2004, 27 shares of McDonald's for $34.10 in 2005, 18 shares of Clorox for $64.61 in 2006 and 25 shares of Clorox for $65.49 in 2007. One thing to notice is how the dividends received to date in the Withdrawal Portfolio are really starting to add up now as $7,406 have been collected on an initial $4,009 investment.

Here are the final end of 25 year results:

DRIP (December 31, 2012)
Company (Ticker)SharesPriceValue
Aflac910.3165$ 52.28$ 47,591.35
Clorox287.4352$ 72.53$ 20,847.68
McDonald's271.1176$ 87.42$ 23,701.10
Target611.2895$ 58.50$ 35,760.44
Year 25 Value:$ 127,900.56
Rebalance (December 31, 2012)
Company (Ticker)SharesPriceValueCash
Aflac622.5$ 52.28$ 32,544.30$ 3,630.06
Clorox422$ 72.53$ 30,607.66
McDonald's363$ 87.42$ 31,733.46
Target516$ 58.50$ 30,186.00
Year 25 Value:$ 125,071.42$ 128,701.48
Dividend Withdrawal (December 31, 2012)
Company (Ticker)SharesPriceValueCash Div.Total
Aflac622.5$ 52.28$ 32,544.30$ 6,083.28$ 38,627.58
Clorox144$ 72.53$ 10,444.32$ 3,527.64$ 13,971.96
McDonald's184$ 87.42$ 16,085.28$ 3,234.79$ 19,320.07
Target420$ 58.50$ 24,570.00$ 3,663.10$ 28,233.10
Year 25 Value:$ 83,643.90$ 16,508.81$ 100,152.71

In the final five year period of this test, the Rebalance Portfolio made a push and is now valued $801 higher than the DRIP portfolio with the Withdrawal Portfolio significantly behind by over $28,000, as would be expected. The final purchases made during the period for the Rebalance Portfolio were all made in Clorox and were 36 shares for $54.73 in 2008, 38 shares for $61.66 in 2009, 42 shares for $63.50 in 2010 and finally 47 shares for $66.61 in 2011.

Observations

I was surprised to see how closely the two methods of dividend reinvestment ended up being in total valuation at the end of the experiment.

By letting the winners run in the DRIP Portfolio, Aflac dominated the account and ended up as 37% of the value at the end of the 25 year period, even though all four stocks performed exceptionally well with every position being worth more than 20x the initial investment.

The Rebalance Portfolio had wide fluctuations in percentage of holdings with Aflac and Target at times being worth up to 37% of the portfolio in the earlier years, but at the end of the period having a remarkably balanced holdings with the largest position, Aflac, being only 0.3% overweight.

I can see where a more diversified portfolio of 10, 20 or more stocks could benefit from the Rebalanced Portfolio approach to help keep certain stocks from dominating the portfolio. The only downside to this approach is that it can prevent getting the maximum return out of the true blue chip winning stocks. The example in this portfolio being Aflac, whose final value after 25 years was over 30% less in the Rebalanced Portfolio than in the DRIP Portfolio. In this case the end result was the same, but in other situations being too conservative could possibly hurt your final returns.

Another consideration to take into account is transaction fees on directed purchases in the Rebalance method. At $10 per transaction, anything less than a $500 incremental reinvestment would be paying more than 2% in transaction fees, which would add up over time and begin to eat away at total returns.

Finally, the Dividend Withdrawal Portfolio also performed exceptionally well as the initial $4,009 investment ended up being worth $83,644 after 25 years and provided an additional $16,509 in dividend income during the period. For comparison, there was $22,662 reinvested in the DRIP Portfolio and $21,800 in the Rebalanced Portfolio. The dividend income for 2012 was $3,455 for DRIP, $3,604 for Rebalance and $2,274 for the Withdrawal Portfolio.

Conclusions

I took away a few important lessons from the exercise. First being that it probably doesn't matter all that much how you reinvest your dividends in the portfolio, it's only important that you do reinvest them if possible. The end result, after 25 years in this case, was about 28% more wealth than if the dividends were collected and used for living expenses along the way.

The second lesson learned is that I need to keep my eye on the long term returns and not worry about the ups and downs along the way. Every one of the positions in this portfolio fluctuated greatly, with McDonald's being down to just 6% of the DRIP portfolio value after 15 years. By starting positions in companies with a great track record, like those on the CCC list, a person should be able to be confident when times get rough and focus on the growing dividend returns and reinvestment into shares rather than the temporary drop in overall value of the holdings.

I hope this portfolio analysis looking backwards can help other young investors as they look forward to their retirement. By investing in strong dividend growth companies, no matter how you do it, you will be rewarded in the long term.

Source: DRIP Or Rebalance? 25-Year Portfolio Analysis To Answer The Question