IFB04: Why DRIP Investing Your Stocks Should be Integral to Your Investing

Listener Q&A, Podcast Show Notes

DRIP investing is one of the untapped resources to investors. It can be one of the keys to growing your wealth. Compounding is one of the eight wonders of the world, according to Albert Einstein. Utilizing it with DRIP investing is a great way to double compound your investments. We will discuss this and much more in today’s session.

How the DRIP works and how it can benefit you

Differences between the Roth IRA and Traditional IRA

Tracking your Brokerage Account

Portfolio Diversification and limits on total number of stocks invested in

How do Bonds work?

What is the best Asset Allocation for my portfolio?

Welcome to Investing for Beginners show notes for Session 04 with Erin. Today we spoke with Erin who is just starting out and recently became a subscriber to Andrew’s eletter. This letter has helped her find a few companies to start investing in, but Erin has several awesome questions for us today.

Let’s dive in to find some answers for her.

How does the automatic DRIP work?

Andrew: Yeah, so this is a very, very key thing to understand. And really a lot of investors, even professionals don’t really comprehend this idea. Or they don’t care to apply it. But it can be so powerful.

It’s one of those things that makes long-term investing so attractive.

So one of the ways that I will try to describe it is this way. Imagine you have a room in your house. Within that room you have a long row of coffee makers. And what those coffee makers do is they drip down into a big vat that you might have. And the vat has a tube that feeds back into one of the coffee makers.

So you buy your first stock, that’s like activating your first coffee maker. And the stock will drip down. And that drip will feed back into back into a second coffee maker. Then the second coffee maker will also start to drip, but it is not going to be as big as the first coffee maker. But it will have that drip going. If you look at the first coffee maker, that drip is slowly getting bigger and bigger.

Now as those drips continue to accumulate, you will see that the second drip is also getting bigger and that contributes to the whole pot. Eventually you will get the second coffee maker to drip just like the first coffee maker.

That is when the two will shift to a third coffee maker. And as you can see as that keeps going and the drips get bigger, bigger and bigger. The accumulation of coffee makers that are able to work will get faster and faster. It basically compounds from there.

In the story, the coffee maker is the first stock we bought. And then as you reinvest the dividends, which is the DRIP. That is like the tube part of the reinvestment.

So basically, any dividends or income that you are receiving from a stock allows you to buy more stock. Those additional shares, even if they are fractional shares will start to accumulate more shares.

Companies that pay dividends, one of their biggest goals is to make those dividend payments increase every year. So that is why I said earlier that the DRIP slowly gets bigger and bigger. Which over time can really become a big DRIP because as the dividend payment grows you’re getting more of an income. And then you might be able to buy even more shares from that.

So what you are trying to do with DRIPs in your investment account is trying to put it on automatic.

Number one when you do tell your broker, we both use TradeKing. All you have to do is give them a phone call. Every stock that I buy they automatically set up a DRIP for me.

What that does is it gives you shares as it goes on. It also keeps you from having to pay taxes. For example dividend taxes, when you receive a dividend income. Though that is another nice benefit from all of this. And really what you getting is I like to refer to as a double compounding interest.

Regular compounding interest is you buy a stock. You give that corporation your money. They grow the business by 12% a year and they are able to do that every single year. And because it’s growing every year. Then you are making 12% and then you are making 12% on the original 12%. So it’s a compounding effect.

Now when you add dividends to that. And you see growing dividends and you are reinvesting those growing dividends. Now we have dividends that are compounding 20% and compounding 20% on their 20%. Plus you are accumulating shares too.

So the first year you received a dividend on one share. Maybe on the second year you received dividends on a share and a tenth. And as you continue to see that grow. It starts to accumulate and all of sudden all of these DRIPs start to line up. Let’s say you have 5, 10, 15 DRIPs all going at once.

The key to it again, is that it started very small. People look at a dividend yield of 3% and think who really cares, right? 5 dollars, 10 dollars, 30 dollars, 100 dollars. Doesn’t seem like much, but that’s not the point. The point is to get to get the DRIP started and then letting it accumulate over time. Then five or ten years later that is when things can really start to accumulate.

I think a big reason why people don’t do it, don’t care to learn about it. Is because it takes at least five to ten years to see any growth. The thing is after that five to ten year initial period you will see tremendous growth every five years. That is the power of compounding.

Dave: The cool thing about DRIPs is that it is free money that you can use to reinvest in what you’ve already bought.

You invest in companies that pay a dividend, that is one of the additional perks that comes along with it.

The 401k that Erin mentioned earlier in the podcast will already have all the funds that issue dividends enrolled in DRIP program. Your employer will have it set up that way.

Every quarter your 401k will automatically reinvest those DRIPs back into your portfolio. This is one of the ways that your 401k will grow and increase its value, by reinvesting those dividends.

If you have an individual stock broker you can have them setup an automatic DRIP for you. Just call them up and ask them to have that setup for your account. They can setup it up pretty easily. TradeKing offers it for free and all you have to do is request it and they will enroll all of your stocks into the program.

They won’t do it automatically, you need to ask them to set it up for you. But it is a must if you are going to continue to compound the money that you have invested in any of these companies.

Compounding interest was first discovered by Albert Einstein. He call it the “eighth wonder of the world”. When someone as smart as Einstein makes a comment like that. It makes me pay attention and want to learn more.

He was absolutely right and it is one of the untouched, not talked about, untapped potential in investing that people just don’t talk about enough.

Andrew: If the stock pays a 3% yield on the $40 then the next year it may grow its dividend which means that the next year it may be 3.8% and the following year 4.2%.

I recently did a study on this for my personal portfolio and you can see a rise in 10% yield in five to ten years. If you can imagine as it increases it’s yield you will increase your shares of the stock along the way. So your one share could quite quickly become two shares, depending on how the company performs in the future.

What is the difference between a brokerage account and a Roth IRA?

Dave: To delve into your question a little bit. So your 401k is an retirement account that your employer sets up for you. It allows you to contribute to on a tax-deferred or tax-free basis to invest for your retirement.

They have choices for you to choose from to allocate those funds. In that 401k you have two different types of accounts that you can choose from. This applies to an individual brokerage account as well.

So in the 401k, you have the choice of doing either the Roth or the Traditional.

The easiest way to think of these is the Traditional is before-tax money. So if you invest $200 in your 401k every two weeks in a Traditional there will be no taxes taken out of that $200. So that money will be invested during the life of its time in the 401k. And when you are ready to retire and start withdrawing money from your Traditional, Uncle Sam is going to be standing there waiting for his cut.

The Roth is after-tax money. So that $200 will already have taxes taken out of it and then when you retire and would like to take money out. That money is tax-free at that point.

Those are some simple ways to think about those retirement accounts.

Now in an individual brokerage account you three different ways you can go.

First would be the standard brokerage account which has no tax implications whatsoever. You have no before or after tax liabilities

In the Roth and Traditional same rules apply. In Andrew’s brokerage account the money has already been taken out by his employer. So when he invests that into his Roth IRA at TradeKing he will not pay taxes on that $200 when he takes it out when he retires.

So any brokerage account like TradeKing, Fidelity, Scottrade or anyone else. They are investing houses that can take your money and invest it in the stock market for you. Within them you have a choice of what kinds of accounts you would like to set up. Depending on what type of tax-benefits you would like to receive.

Andrew: Because I am very young and I expect to have a higher income later in life than I do know. Just having started my career five years ago.

So basically I will eat the tax liability today so that when I take it out later. In theory I am not paying as much tax as I would have paid right now because hopefully I have a ton of money in the future.

Dave: To add a little bit more info. To discuss dividends, like Andrew likes to talk about. When you invest in dividends a Roth IRA is a little better vehicle for that. Because the tax-implications are that it is free. So with that $200 that you invest. With the dividends that you earn on that money. Over the life of the investment, however long you have it in that account. You will never pay taxes on that portion of the dividends.

If you hold the money until you’re 59 ½. Keep in mind that 59 ½ is the golden number when talking about IRAs. When you reach 59 ½ you can take any of the money out the account without paying any taxes on those monies. If you leave it in for 35 years and accumulate those dividends you will never pay taxes on any of those funds, including the dividends. Ever.

Can I log into my brokerage account and see the progress of my stocks?

Andrew: Yes, easy question, easy answer.

Dave: Answer is yes. But the question I would want to ask myself is do I really want to look and see how my investments have done each day? I mean we are emotional beings and if we see the stock went down a few points, would we freak out and want to sell? Or see it go up and we get a little irrationally exuberant and think we have to buy more?

I personally don’t like to look at it every day.

Erin: I totally understand that and I can see how that could be a problem. I look at it every day as a way to learn for myself. I want to see what happens so I can learn from that. I have seen it go down and I have to tell myself that it’s okay. I am in it for the long-term.

Andrew: And what I like about TradeKing is they send me an email every time I get a dividend. You mentioned how do you know when you get that dividend to be reinvested. I like when I get that email and open it. Makes me happy because I just made some money. And a couple of days go by and I will my share numbers increase. Usually a percent or a fraction of the share that it went up. But you do see it go up and that reflects in your total gain/loss percentage. When you look at the complete position. So you will see that reflected in a few days.

You mention in your eletter that you look to own 15 to 20 positions in your portfolio. When you reach that number do you start to reinvest in those companies?

Andrew: That is a great question. I like to talk about when I start to get close to that number in portfolio and how I like to pare down my portfolio. It’s at those times that I will re evaluate and try to see which stocks have done well but the company behind it isn’t doing as optimal as it should be. And maybe taking some gains off there.

So, that is what I did in the January issue. I ended up selling four positions and in each case the results over a year’s time was not what we were hoping for. And having the fortune of already being diversified in my portfolio those shares had already gone up in value. I was able to take the benefits of buying the stock when it was cheap and selling it when it wasn’t as cheap. Even though the business didn’t do as well as we hoped. We were still able to make a profit.

So, that’s what I did.

And for your question about wanting to add more. I would probably try not to and just keep to the same. Adding $150 to whichever new stock pick there is.

One reason is that once a lot of these opportunities have gone up in share price. Maybe they have gained 10%, 20%, or 30%. At those new prices they may not be as great deals as they were back before they saw their share price go higher.

At the same time, if I had the opportunity to pick between a new opportunity on one hand. And then I have an old opportunity on the other. You must have a process in place and one of the things I like to do with my investing is buy stocks at a discount. Based on what they are really worth and based on other principles such as staying diversified and holding for the long-term.

But, we have this system in place not thinking that every stock is going to be 100% perfect pick. But that over time, applying these principles and sticking to the system will give us better results over the long-term.

And so if I take two equal positions and look at them. One is a stock that hasn’t moved in six months since I recommended it. And one’s a new opportunity I would rather be a little bit humble and realize that I don’t need to sell the stock that hasn’t gone anywhere. But the fact that the market hasn’t realised how under priced it is. I am going to add to my position anyway maybe I will just put that in there.

I guess it depends on how much money you are adding each month. If it is variable, I don’t know. For my eletter portfolio, it is always the same $150 per month. So I am always adding one new position.

You could add if you had excess money and wanted to add it to some new positions. But definitely I would do that with stocks that have not run up yet. Because the stocks that have run up are definitely not as great of deals as they used to be.

And sometimes a new opportunity is a better one than an old stale one.

Dave: I don’t have a lot to add to what Andrew was saying. As usual, he was right on the money.

The way that I do it is I have right around 15 stocks in my portfolio. And every month I just add more to them.

The way that I look at it is. I am older and I don’t have as much of a time frame as Andrew does. Really I am buying these companies for my daughter. I am trying to set this up as a means for her to use it however she would like to. So I look at these companies as something that I am going to basically hold forever.

I just keep adding to the positions as I go along. I know that Andrew splits his portfolio into two groups. But I look at my portfolio as all dividend fortresses. Unless I have made a choice that a company is doing poorly or the value has not be realized after a year or so. Like Andrew was saying. Then at that point I may make a decision to sell that position.

In the last three years, I think I have only sold two stocks. So that is not something that I really do. When I buy them I have confidence that they will go up, that I’ve made the right decision.

I think I have done all the research and think it is a good company. And I am going to sit on it and wait for it. Because my time horizon is not the next ten or fifteen years when I am going to retire. I am looking at my daughter, who is four. I am looking at trying to set her up when she is 50 or 60 she has different options to choose from at the point.

How do you diversify? Do you split your portfolio up by 75%/25%? Or do you do 50%/50%? Also, how do you purchase bonds, can you buy them through TradeKing?

Andrew: I got the 75/25 or the 50/50 from Benjamin Graham, he is one of the investing legends. He was around back during the Great Depression and he was able to make substantial returns during the recovery after the Great Depression.

He wrote numerous books, he was a professor of economics at Columbia Business School.

His recommendation was to do some mix of this split, depending on what you were comfortable with. And in the financial planning industry you will hear things like this as well. They tend to call it asset allocation. And what they do is tend to vary that mix based on your risk profile. And they tend to make that risk profile decision based on your age.

So basically the thought process is as you get older you want less risk because you’re going to have to retire soon. A market downturn like we see every so often would be very detrimental if you are close to retirement. So they tend to do more bonds than stocks.

So bonds do move in price as well. But the way that works is that your are just basically taking your money and loaning it to somebody. And they have to pay you back. So as long as that person you are loaning the money to doesn’t go bankrupt or have any ability to pay you back. You will tend to have the ability to get the full value of the bond back.

You can do this thru government bonds which historically have been very safe because the US government has the Federal reserve and the printing press. Which has allowed them to pay off anybody’s bonds. No matter what has happened.

No one knows what is going to happen in the future but government bonds are one of the safest.

You also have the option of buying a corporate bond where you are lending money to a corporation. These are publicly traded and available online.

I’ve done some research on them and it’s tough because generally, you need at least $5000 as a general rule of thumb to buy a single bond.

There are a couple of bond screening tools that you can use in the similar fashion that you use for stocks. Morningstar has one and the options that I looked through for corporate bonds offer bonds for around

$100 million dollars and a second offering for $90 million. It was kind of ridiculous but there are some good ways to get bond exposure that any average investor can do.

There are bond ETF funds which work just like an index fund. Those tend to be a lot less volatile than stock fund. You will see them kind of hovering the same price and then you are just collecting the dividends. Which are bond coupons like any that are paid out. This is one way to get exposure.

Let’s say you were going to do a 75/25 mix of 75% stocks and 25% bonds. All that means is that if I have $1000 in a portfolio, $250 of it is going to be in bonds. The rest in stocks.

If you do want to buy an individual bond you would go through TradeKing. They have their special ticker that they use. The Same rule applies if you are going to buy a bond fund.

I would recommend before you buy any sort of ETF you would want to go online and look at the prospectus for that fund. You can do this at google finance or yahoo finance.

Look for things like the expense ratio. Find out whatever the fees are. How much you are paying in management fees and general portfolio maintenance. Figure out what kind of holdings the ETF has. There is big difference in a ETF that buys thousands of junk bonds and calls that diversified safe portfolio. And one that buys high-quality, blue-chip bonds that have been around for decades and likely will be around for more.

You are going to want to be smart about it. Unfortunately there is not set it and forget it when it comes to investing. There is always, at least a basic understanding of what’s going on that needs to happen whenever you jump into any sort of investment. The nice thing is once you have that base level you can apply that.

The same way you look at a bond ETF and the information on it may seem confusing. The same thing can happen when you are looking at stocks. Looking at how to analyze and how to figure out which ones are good and which ones aren’t. But as time goes on you start to become more comfortable.

The important thing is to look for the bond ETF prospectus, look at what bonds they are holding and what fees they are charging. Maybe look at what volatility I can expect with a fund like this. And these are the dividend or coupon payments that I can receive.

So for myself personally I have written about bonds and I really respect Ben Graham’s recommendation to buy bonds. Personally, at my age, I am at such a young age that I honestly don’t care if the market loses all of its value tomorrow because I am not going to be pulling out my money anytime soon.

So having bonds is nice for having income that you can take and reinvest it. That’s one really great benefit of having bonds over stocks. And that is why all of my stocks are dividend payers and we talked about the DRIP earlier at the beginning of this episode.

So I am getting my income from that and using that to funnel back into my compounding, making it much higher. As a result, I don’t really need to buy bonds.

My last point is that you can also use bonds if you have a sense of where the market is going go. As a general rule bond prices do follow stock prices and vice versa. You will never find the perfect time to buy bonds and the perfect time to buy stocks. All asset prices expand and contract and there is never one that is completely a perfect buy while one is perfect sell.

So don’t think of bonds in that sense of I can manipulate the market and that’s when I am going to buy bonds because that is when stocks aren’t good buys.

But bonds can be good purchases if you feel that the market is going to go down in value because if you are going to buy bonds and hold them just for the payments you are going to receive. Then you are going to care less where the bond prices go.

If you have some intuitive sense of where the market is going to go and you pull out some of your money in stocks, then you have saved yourself some losses. And put it into an income generating asset that won’t go down value like investing in stocks would be.

Editors note: A few resources for bonds

Yahoo finance-bond screener

Janus Capital Group-Bill Gross Investment Outlook

Bill is considered one of the leading experts in the bond field.

Great letters and very easy to read.

Bonds for dummies cheat sheet-great bond 101 resource

Dave: My first question would be do you have any bonds in your 401k? If you do then maybe that could cover your bond investing needs at this time. I have a portion of my 401k allocated to bonds. I have a 5% allocation to international bonds and 5% to a US bond fund.

For my stand-alone brokerage account, I don’t worry about investing in bonds because I have that covered with my 401k. And because my employers match my contributions I am not worried about having enough money allocated to the bond portion of my portfolio.

I don’t use them for my Roth IRA. I have done some research on them and have a written a post about them. I have tried to learn about them and have read a fair bit about them. But to be honest they are a completely different beast than stocks and whole different world.

And frankly, I don’t feel intelligent enough to tell you how to go out and buy one bond on its own.

My recommendation would be to first to ask yourself what are comfortable with your risk tolerance. That’s the most important part. How comfortable with following what Andrew is teaching you and taking his information to buy those companies. Which I think is a great recommendation.

Secondly, if you are comfortable with all of that and you have bonds covered in your 401k. Then maybe at this point, it is something that you don’t need to be concerned with.

At this point in your investing career, maybe worrying about bonds is not something that you need to be allocating a lot of time too and maybe is not necessary at this time.