The Double-Edged Sword With DRIP Dividend Investing

by: Tim McAleenan Jr.

According to the DALBAR Study that I have cited a couple of times in some of my Seeking Alpha writings, the average retail investor underperformed the S&P 500 as a whole by four percentage points annually during the 1991-2011 stretch. As you can see for yourself by clicking here, the average equity investor achieved returns of 3.49% while the S&P 500 returned 7.81%. Because of statistics like this, a rising trend in recent years has been to take a look at the behavioral factors that drive investment decisions.

This is an important development. If we can diagnose some of the areas where we have a natural tendency to become irrational as investors, we can put our guards up and be aware of the areas where we could be especially prone to irrational decision-making. Today, I would like to talk about one phenomenon that is applicable to investors that steadily invest in dividend stocks by means of DRIP Investing. It is something known as "commitment tendency" or "escalation of commitment bias." Essentially, with every monthly check you cut out to purchase $100 of Exxon Mobil (NYSE:XOM) or $100 worth of Coca-Cola (NYSE:KO) stock, you are making yourself more psychologically committed to the company.

While the "escalation of commitment" term traditionally refers to any act that follows a "throwing good money after bad" situation, its application is not limited to negative situations. It can refer to any situation where previous commitments create some type of emotional attachment that frames future decision-making. As Charlie Munger, the Vice Chairman of Berkshire Hathaway (NYSE:BRK.B), explained it in his "Psychology of Human Misjudgment Speech":

Fourth, and this is a superpower in error-causing psychological tendency: bias from consistency and commitment tendency, including the tendency to avoid or promptly resolve cognitive dissonance. This includes the self-confirmation tendency of all conclusions, particularly expressed conclusions, and with a special persistence for conclusions that are hard-won…

And all these things like painful qualifying and initiation rituals pound in your commitments and your ideas. The Chinese brainwashing system, which was for war prisoners, was way better than anybody else's. They maneuvered people into making tiny little commitments and declarations, and then they'd slowly build…

DRIP Programs are a phenomenal tool for steady wealth-building, particularly for investors that are starting out with small sums. You can visit Procter & Gamble's (NYSE:PG) investor website and sign up to have $50 (or more) taken out of your checking account each month to buy shares of the company, without any fees attached. It's a great way for the "little guy" to become wealthy by participating in Procter & Gamble's 12.80% annual returns since 1970.

There are plenty of other companies that offer free DRIP investments as well. If you make a $1,000 commitment to an initial block of Bank of America (NYSE:BAC) stock, you can then make $50 ongoing purchases free of charge. Becton Dickinson (NYSE:BDX), Dr. Pepper (NYSE:DPS), and Aqua America (NYSE:WTR) allow you to invest at much more palatable $0-$250 amounts. When properly harnessed, the acquisition of company stock month after month for years on end can create meaningful amounts of money that can grant you financial independence.

But here is the thing that should be at the forefront of your mind: the monthly commitment to the same stock over and over for years on end can cloud your judgment of the company going forward. If you've successfully been purchasing Altria (NYSE:MO) stock every month since 1996 and have seen the fantastic levels of wealth created by Altria's growth and the spinoffs of Philip Morris International (NYSE:PM), Kraft (KRFT), and Mondelez (NASDAQ:MDLZ), it can create a situation where it would be difficult to analyze when it would be the appropriate time to sell Altria stock (if the business deteriorated) because you have been making regular contributions to the company for 17 years and have seen how much wealth it has created.

In some cases, this commitment can have pleasant effects. If you've been DRIPing into General Electric (NYSE:GE) stock for ten years, you might have continued buying the stock when it fell to $6 per share because you have grown accustomed to seeing that $100 go into General Electric every month and your commitment bias could be strong enough to overcome the dividend cut and rapid share price depreciation that occurred during the market meltdown. The habit and familiarity of seeing the same amount of money put into the same company every month can create the kind of entrenched investment that prevents an investor from selling low. This is no doubt the upside of commitment tendency bias.

I mention all of this for one reason. Most of us are interested in becoming intelligent, rational investors. But as behavioral studies are quick to demonstrate, most of us do not succeed in that regard. DRIP investing is a unique beast because it requires us to make regular commitments to the same company. As Charlie Munger and other behavioralists point out, the act of making regular commitments often leads to emotional attachment. This has pleasant effects when it prevents us from selling low, but it can have a ruinous effect if it removes any objectivity from our analysis of a company's future potential. If you have been DRIPing into the same stock for years on end, you should take a moment and consider whether you have developed an emotional attachment to the stock. Usually statements like "AT&T (NYSE:T) will always be here!" or "I love my IBM (NYSE:IBM) stock!" can be indicators of these kinds of biases. Personally, I feel an obligation to perform extra scrutiny on my DRIP holdings to guard against falling victims to the effects of this bias.

Disclosure: I am long BAC, GE, BDX, PG, XOM, DPS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.