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Many investment advisors advocate for the use of dividend reinvestment programs (DRIPS) in their client’s portfolios. Some brokerage accounts actually have the setting defaulted to automatically reinvest dividends into the underlying companies when a customer opens a new account. I believe this is a big mistake.
Take a look at the share prices of Best Buy (NYSE: BBY) and Hewlett Packard (NYSE: HPQ) today. They are making new 10 year lows. The business model of both of these companies is broken. However, both companies have had a history of paying a nice dividend. If an investor had been banking those dividends for the past decade, they may still be down in both positions, but they would have had a substantial amount of their initial investment recouped, just from the dividend checks.
The story is quite different if they participated in a dividend reinvestment program, as the majority of those dividend payments over the past decade would have been reinvested in the companies at much higher prices, eroding the value of all of those dividend payments.
The underlying problem with DRIPS is that very few businesses stand the test of time. Industries change, technology changes, consumer tastes change, and companies have to keep reinventing themselves if they are going to survive. In many cases this simply does not happen.
Just ask the shareholders of Eastman Kodak (NYSE: EK). It paid a healthy dividend for the past 50 years. If you had invested in the company 50 years ago, and had been banking those dividend checks, your initial investment in the company would have been worth a small fortune just from all the quarterly dividend payments you had received.
But if you had been participating in a DRIP, all of those dividend payments, and all of that cash would have been gone when Eastman Kodak filed for bankruptcy earlier this year. You would have lost it all.
DRIPS work great is companies that continue to grow and stand the test of time. But most companies do not. Placing all your bets that the companies in your investment portfolio will be there when you retire is simply a very scary bet to place. The best way to continue to build your portfolio is to bank those dividend checks and invest them in other stocks and other sectors. Those dividend checks are the natural way to diversify out of core holdings, because very few companies last forever.
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