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It's Compound Interest That Works, Not DRIPs.

I chose to comment in a recent article by Michael Nadel. I tried to make the point that a weakness for DRIP investing is, that when done blindly, it results in investment in overpriced assets. Reinvesting dividends should require the same thought and care that one would take when injecting new money. Furthermore, I went on to state that thinking of dividends as "old money", or "house money" (my words, not his) was dangerous because it could lead some investors to consider it disposable. In follow on conversations, the concept of "paper losses" was mentioned, and I grouped that into my diatribe. Although the response I received was clearly cold… some might say hostile, I chose to persist. SA readers would be justified to ask why, and I hope to make it clear.

A Long, long time ago…

I'd like to start out by telling a little story.

I started investing with real money in 2000-2001. At that time, I was getting ready to get married, and wrapping up a college degree. I had almost no money, and almost anything I saved at the end of the month went towards paying off accrued debt. Because I had so little money, I threw what I had into a couple of stocks, my best ideas, on Sharebuilder, and thrilled in the idea of reinvesting my dividends for free. I focused on evaluating small, under-covered companies, and for years I did quite well. But my methodology evolved over time, and I ended up with two portfolios, one built for capital gains, and one for income through dividends.

Over time, the dividend portfolio began to get overweighed with BDCs and REITs. They weren't the only positions I had, but they had appreciated the most, and the dividends were hefty. I set them up for automatic reinvestment, and the positions kept getting larger and larger. My favorite stock at the time was Allied Financial (NYSEARCA:ALD), with over 40 years of dividend payments, and dividend raises. It would frequently drop due to short attacks, and I was thrilled with the hefty purchases of stock my dividends were starting to make.

In mid to late 2007, everything begin to turn sour. ALD, ACAS, and my REITs weren't looking so hot. I had expected a downturn, and had convinced myself that the dividends would buy up shares at depressed prices, and a few years down the road I would be celebrating my fortitude. Except that the meltdown proved to be more damaging than I predicted. Prices kept dropping, but I took comfort that I was experiencing "paper losses", not real losses. Everything would work out in the end.

Unfortunately, ALD, and companies like it, have a business model that depends on the ability to sell stock to raise money. That money is then lent to small and mid-sized businesses for either interest income or equity stakes. With the drop in share price and liquidity dry up, many of these businesses could not pay their loans, much less maintain their lofty dividends. ALD's 40 something years of dividends meant nothing in 2008. I rode it down from $28 a share to $4 or $5 a share. Everything dividend I'd ever received was lost.

I was already struggling through one of the toughest years of my life, and now I had to deal with a crashing portfolio. I couldn't emotionally grasp that my biggest money makers were now loadstones around my neck, and I literally couldn't decide what was a good investment and what was a bad investment. I wanted to let everything ride. I wanted to let things fall to zero or recover spectacularly. Instead, I reset. I sold everything but my most conservative positions, and began to buy new positions. I resolved to sell any positions I felt I'd "fallen in love with". I'd wait 31 days and then reevaluate the position. After 31 days, most of them did not look appealing at all.

Lessons learned

I learned most of my most valuable lessons from 2007-2008. First, I learned that managing two portfolios was silly. My goal is to build wealth, whether that comes from dividends or capital gains is ultimately unimportant. Managing one portfolio is difficult enough, so I consolidated all my holdings. I may employ different strategies with different purchases, but their returns are all tracked together.

Next, I learned that 30, 40, or even 50 years of consecutive dividend payments/raises can be deceptive. Some talk of a dividend culture, and I'll buy that a lengthily dividend history is important for DG investors, but it is of less importance than free cash flow. A company without free cash flow won't be maintaining or increasing dividends for very long, regardless of their past. A BDC pays out almost all of their cashflow to their investors. In many ways, every year is a reset in terms of cashflow. An investor, dividend aficionado or otherwise, should pay far more attention to where future dividends will come from, than what past dividends were.

I learned that dividend reinvestment can be a double edged sword. Those BDC investments, that look so poor in retrospect, paid me tremendous amounts of money in dividends. I could have used that money to purchase many other investments I had my eyes on. My portfolio was still small, and could have used some diversification. But I convinced myself that saving some dollars on commissions to buy something that just kept paying me more and more was a no lose proposition. Furthermore, every three months, I lost a chance to search for better investments. Auto reinvestment meant I didn't have to think where the dividend was going. If I didn't automatically invest it, I'd have to carefully analyze where I allocated that dividend. It's doubtful that ALD would have been my investment of choice every quarter.

Finally, and probably, most importantly I learned to treat current market prices as the going price. The day I buy GE at $15, that price point becomes irrelevant to me. If it falls to $13, than my baseline is now $13. The question I ask myself is can GE grow x% from $13. I don't think about how much I'm down on the specific stock. I save that measurement for my overall portfolio.

The idea is to avoid justifying holding a stock after a big fall with the goal of "getting back to zero". Not thinking about "paper losses" helps to avoid loss aversion as well. We all have a tendency to avoid regret. Richard Thaler, Daniel Khaneman and many others have studied why it is investors tend to avoid selling losses after bad news has been released. After all, if the efficient market hypothesis manifested itself in reality perfectly, stock prices would almost instantly adjust to a lower price after bad information goes public. Instead, we see a drop, and then a prolonged slide in prices over weeks and months. James Montier details the phenomenon well in his creatively titled book "Behavioural finance", which can be found at my old friend (NASDAQ:AMZN).

Back to the Dividend Argument

I'll save the "paper loss" discussion for another time. There was more defense to that concept than I can address in this article and keep any kind of scope. The main point of the article was addressing benefits of DRIP, and it's the author's points, and others that I will address with the rest of this post.

First, I'd like to state that I'm not against ever reinvesting automatically. When you feel that a position is cheap, and it's easy to turn on and off automatic reinvestment of dividends, then do so. One of my brokers allows me to do it with a toggle switch. Furthermore, there are plenty of arguments for ALWAYS using DRIP that you should consider. While my critics consider my thought process, "ridiculous" or "crazy thinking", or simply incomprehensible, I understand the appeal of their arguments.

When those arguments are rational, they are perfectly valid. DRIP can be a perfectly rational course of action. Arguing that dividend investing is like owning a car wash, and DRIP is like buying more car bays is mainly an argument for reinvestment, not for DRIP specifically. To argue that one should stick with "what's working" is somewhat of a dodge as well. I thought "what's working" is the overall strategy of dividend growth, and the overall goal was as much income as possible for as little risk as possible. Would a car wash manager invest in a new car bay without considering costs and return on investment? No. He/She would look at where the money can be invested most profitably and do so. When car bays are prohibitively expensive, the manager may buy more efficient nozzles, or a more efficient pump.

One valid argument I've seen put forth are that DRIPs are better for those with small portfolios. First, it is true that commissions will eat up much of the benefits of reinvestment for anyone only earning a hundred dollars a quarter or so. But by the time you have a portfolio over $25000, you could be producing several hundred dollars in dividends.

Furthermore, you are hopefully adding additional capital to your portfolio to be invested. If you have a small portfolio, it is probably reasonable to assume the amount you are able to squirrel away is not overwhelming. Won't commissions take a big bite out of those small contributions as well? Could we possibly be better off combining our dividends and our contributions to purchase the most underpriced/most promising assets we can find as fast as we can get the money together while taking the smallest hit possible from commissions?

In addition, while a portfolio is small, it also likely lacks diversification. I'm not one who feels every portfolio has to have 40 positions. In fact, I feel diversification is one of the most overrated "protections" proffered by financial pundits. But, a small portfolio dominated by two or three positions is a recipe for disaster. We should be looking to get as much capital together as quickly as possible to open other promising avenues of income.

Some talk about using automatic reinvestment as a way to hedge their risk against new picks poor performance. They call it giving their portfolio balance, by investing dividends in winners, and investing contributions into new finds. Perhaps winners will continue to outperform the new positions, and these dividends purchases at higher and higher rates will feed an overall return. But investing is a probabilistic venture. It IS true that we don't know which positions will outperform which on a given time scale (at least I'm no good at predicting it). But we DO know which ones we think are a good purchase, and therefore, which ones have a better chance at performing well over the mid to long term. If you consider a position to be overpriced, and another underpriced, you have determined in the long run that the second position will produce more income or more total value than the first for every dollar you spend.

Why wouldn't we just sell some of the first position and invest it into the second? We could do this, and incur a transaction fee to sell the stock, incur capital gains taxes, on the sale, and then incur another transaction fee to buy our new stock. Or we can simply collect dividends, which we will pay taxes on one way or another, and pay our broker's fee to buy the new position. For a small account the transaction fees make a bigger difference, but our dividends are likely to be a much smaller portion of the new funds we commit to a purchase. One could argue the dividend is too small to bother with, but as I said previously, we probably want to diversify out of the few positions we have. For a much larger portfolio, the question becomes six in one hand, one half dozen in the other. Unless, our capital gains are substantial (assuming a taxable account) our extra costs from funding our purchase through stock sales don't matter as much. Still, the argument that "we can always sell stock of an overpriced position, rather than stop reinvesting in it because the extra costs won't make much of a difference", doesn't seem like a strong argument pro DRIP.

Of course, the difference between reinvesting in cheaper companies vs. automatic reinvesting is likely to be small, and most of the real benefits come early on when portfolios are still small and under diversified. But the real reason I dislike automatic reinvestment of dividends as a set rule is behavioral. I'm told that reinvesting takes the emotions out of the process, but I don't buy that. When I see my money reinvested, I'm not devoid of emotion. I see it purchase more shares, and I'm happy. I think about how next time, I'm going to see an even bigger number. I think about the recent raise in dividend payout and I extrapolate that into the future. There's lots of emotion.

What I've taken out of the process is reason. I don't have to consider whether I bought the shares at a good price. I don't have to reanalyze the company, which saves me time, and that is important. But I'm also less likely to revalue the company than I would be if I was deciding whether to invest my returns in it or not. I can say I'm not being complacent all I want, but if my reason for auto reinvestment boils down to "it's easier", than that is exactly what I'm doing.

Bottom Line

In an ideal world, we would analyze all available information on a company before making any investment decision, and we'd do it all from source material not subject to bias or interpretation. We would do all of this rapidly and with little emotion. Unfortunately, we don't have the time, mental capacity, or probably the desire to do that. So we build tools out of rules of thumb, heuristics, and shortcuts. We need to remember these tools are necessary evils; they allow us to determine a course of action on something we can't fully analyze, but they come at a price. Data gets distorted, facts get spun and framed under certain perspectives, and we lose perspective on which pieces of information are more important than others. We fall in love with our chosen companies, our chosen investment doctrine, and our chosen shortcuts, flaws and all.

Automatic dividend reinvestment is nothing but a tool. It can save you time, but it costs you full control of where you allocate your resources. More importantly, it can lead you to view new money (the dividend) as part of an investment decision you already made. When that happens, it can be easy to be laissez-faire about that money's ultimate performance. To me, the benefits do not outweigh the potential costs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.