There has been a remarkable increase in investment correlation over that past 10 years. Correlation measures the degree to which prices of assets move together. Currently, equities, corporate bonds, and REIT purchases are being driven by risk-appetite. Conversely, USD, precious metals, and "safe" sovereign debt are acting as safe-havens during times of risk-aversion. The increased correlation across these asset classes is resulting in higher market volatility, causing many retail investors to remain on the sidelines.
The growing use of program trading by large institutional traders is partly responsible for the increase in asset correlation. In the current economic environment, trades are based on headlines from around the world. Comments from the Federal Reserve or the European Central Bank, for example, trigger buy and sell orders in all asset classes, all over of the world, all at the same time. As a result of this rapid-fire trading by the market's biggest players, markets are increasingly moving in a risk-on/risk-off fashion.
Because program trading makes up a large percentage of the volume on the major exchanges, and the trades are being driven by headlines, fundamentals and basic technical analysis are not currently reliable methods for predicting market moves. With stocks, corporate bonds, and REITs being almost interchangeable from a risk-perspective, retail investors are in a unique position to leverage some rather traditional investing methodology. Retail investors need to get off the sidelines and get back to basics.
Many dividend growth investors support automatically reinvesting the dividends from positions in companies like Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), and Kraft (KFT). Automatic dividend reinvestment is very much like dollar-cost-averaging; in that, investors purchase more shares when the dividend coincides with a low share price and fewer shares when the dividend coincides with a higher share price. This technique lowers an investor's average basis in a position. Also the automatic reinvestment removes the psychological aspect of whether or not to invest in something new or add more to another position. There is value in simplicity, but the opportunities presented by the current risk-on/risk-off market environment warrant discretion with regard to when and how dividends are invested.
Dividend reinvestment plans (DRIPS) automatically reinvest in the company paying the dividend; thus increasing the risk-on part of a portfolio. A selective dividend investment plan (DIP) using the same large, income-producing blue-chips allows investors to leverage both sides of the risk trade; the risk-on equity builds the risk-off cash position. Building cash allows one reevaluate positions quarterly and to invest opportunistically at favorable prices. Investors cannot afford to blindly increase the same positions regardless of share price, company fundamentals, and/or market environment. With volatility at historic levels, highs and lows are coming much more frequently, making buying at relative-lows much easier to do. If the fundamentals of an investment don't change, and the dividends continue roll in, buying risk-on dividend-paying equities during risk-off markets will generally result in a favorable cost basis and a solid income stream.
As long as headlines trigger program trading platforms to execute risk-on/risk-off trades, markets will continue to swing dramatically. Automatic reinvestment of dividends in this type of market will almost certainly lead to less-than-optimal reinvestment during risk-on periods, resulting in a higher purchase price and fewer shares purchased. Retail investors are better served by taking dividends as cash, staying nimble, and selectively picking off income-producers (bond or equity) when the market loves them the least.