In the last article, I discussed how it is that a DRIP program can create a capital flight scenario that can be extremely destructive to your overall position. Through exposure to dilution and unrealistic growth expectations, DRIP programs can sometimes be hard to justify, even with yields of over 5%.
However, using a couple of accessible tricks, a personal investor is still able to benefit from the fantastic reward opportunities of a DRIP program, so long as they are wary of the potential risks involved. Today, I’ll dive into one of these tricks, and include a discussion about how to manage the respective risks of the new positions.
One of the best ways to mitigate the risks of a DRIP program is to limit your exposure to mutual funds. By taking advantage of a DRIP program from a Mutual Fund, as opposed to a specific security, you are less exposed to the effects of dilution. Specifically, you will no longer be exposed to the risk that dilution will reduce the demand for securities.
While re-investing a cash dividend requires that investors continue to purchase stock, and therefore support its price, a DRIP means that investors can simply wait for the next dividend period and receive free equity. By adding a time-value to the securities (ie. I can buy it now, or wait for it and get it free later), a DRIP program marginally increases the demand for a position.
However, because Mutual Funds are always redeemable by the Fund itself, there is never an issue of volume. There will always be a buyer of a given mutual fund, and there will always be a seller. This means that investors are less likely to run away from their positions, and therefore continue to support your own. In addition, Mutual Fund DRIPs are a somewhat more robust function, in that they come with the diversification inherent to the fund itself.
Instead of bloating out a single position within your portfolio, a fund DRIP increases your broadest holdings, and therefore actually increases your diversification over time. Again, this provides negates the risk that investors might suddenly dump on your position, once they realize that it has become overweight.
Understanding how it is that a Mutual Fund can greatly improve your ability to reduce the risks associated with a DRIP, some new avenues for earning yield begin to open up. By opting for DRIP distributions from your broadest holdings (ie. Your most boring positions), you will likely be able to increase your returns from those sections of your portfolio by an incremental amount, and improve the safety of the holding by allowing it to allocate more funds towards the positions themselves, as opposed to redistributing all its cash to investors.
Lastly, it allows you to scale your portfolio in accordance to your own terms. Because the Mutual Fund position now grows organically, you can structure your own cash injections into your other more aggressive holdings accordingly, thus helping you to create a solid financial plan for the future.
