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How to Build a DRIP Portfolio

How to Build a DRIP Portfolio

Constructing a DRIP portfolio is easier than you think

Whether you’ve been investing for years or are just starting out, you may think that creating and maintaining a diversified stock portfolio is a daunting task--one that’s better left to the professionals. But the truth is you can minimize risk, build a stock portfolio and cut costs by doing it yourself. While the importance of a secure and conservative stock investing strategy cannot be over-emphasized, the difficulty of constructing such a portfolio can be (and probably has been!) over-stated.

Regardless of your age, investing can trigger emotional reactions that lead to mistakes, so the most important trait you need is patience. After all, investing is a long-term...even lifetime...pursuit. The traditional advice to review your portfolio at least once a year still holds true, both because your companies may have changed and because you may have changed.

Picking stocks

"Don't put all your eggs in one basket" is the conventional wisdom. It's also good advice. When some of your stocks are lagging, others may be gaining. This way, you won't feel pressure to sell the laggards. In fact, if a company’s fundamental strength hasn’t changed, you would want to be buying its shares when they are lagging, not selling them.

Unfortunately, many people are intimidated by the prospect of choosing five or 10 stocks. That's why so many opt for owning a mutual fund and abdicating the responsibility. But mutual funds have their drawbacks. Some charge high fees, perform poorly and have a short-term focus. Worse, they may saddle their investors with unwanted taxable capital gains distributions that can occur even when the fund is down. And investors may be clueless about the companies owned by the fund.

Picking stocks for a diversified portfolio doesn't need to be intimidating. Even legendary fund manager Peter Lynch, who once ran the largest mutual fund in the country at Fidelity, has said that individuals have the advantage over fund managers. He urges people to start by "buying what they know" and holding for the long term. If you are still wary about choosing your own stocks, we offer four starter portfolios of five companies each for you to get started. When you have gained more confidence, you can begin choosing your own companies instead.

DRIPs give people an additional advantage. Since you don’t use a broker, you can invest small amounts on a steady basis, rather than having to risk several thousand dollars at once. "Buying what you know" simply means investing in the companies whose goods and services you...and millions of other consumers...use daily. Of course, that's just a starting point, but, as the saying goes, "a journey of a thousand miles begins with one step."

Combine this idea with the concept of owning a handful of basic industries...such as food, banking, oil, utilities, and health care...and building a portfolio becomes manageable, even easy. These industries provide goods or services that people need on a steady basis, making them somewhat recession-proof. Chances are that you can find at least one company in each of these industries that is familiar and is enjoying a lot of "repeat" business.

Making choices

After you identify familiar companies in the five basic industries, determine which competitor in each industry represents the best investment. Remember that you're focusing on the long term, not trying to "bet" on a company that may surge over the next weeks or months. You can research companies and industries using such sources as the Value Line Investment Survey, available at most libraries, or online information from sources such as Yahoo! Finance or MSN's MoneyCentral.

You should also rely on your own common sense. Companies that are laden with debt will have a hard time growing profits, just as individuals with hefty credit card balances have a hard time saving money. (Certain industries are exceptions. For instance, utilities must borrow heavily to build new power plants, and banks’ liabilities are high because they include depositors' money.) Debt-laden companies must devote much of their operating profits to interest expense, and are hurt more than debt-free companies when interest rates rise.

Another basic yardstick is a company's price/earnings (or P/E) ratio (the stock's price divided by earnings per share). By calculating a stock’s P/E, you can easily compare it with other companies in its industry to see if it represents a good value. Unloved stocks will have lower P/Es than ones that are enjoying great popularity.

Value versus growth

Companies are typically classified as "growth" or "value" stocks. Growth stocks increase revenues and earnings at an above-average rate, but pay little or nothing in dividends. By contrast, value stocks typically have slower...albeit steady and reliable...growth and pay more in dividends. As a growth stock (and its industry) matures, its rate of growth may slow, so it may reward shareholders by increasing its dividend.

It’s best to own a mix of growth and value stocks because they tend to take turns leading the market. For instance, in the late 1990s, growth stocks were in vogue, with very high P/Es, causing some experts to warn that even the slightest corporate misstep could cause the stocks to decline. Value stocks were out of favor, as evidenced by their relatively low P/Es and higher yields. (Yields in general had declined for both groups, partly as a result of more favorable tax treatment for capital gains, compared with dividends.) After the bear market of 2000-2002, value stocks rebounded more quickly than growth stocks.

Investing for the future

Investing for the next several decades requires two commitments: getting started now and adding to your nest egg regularly over the years. Many people give in to the inertia of indecision and a feeling of helplessness, so they simply don't get started. But as we've said, you are the best analyst you can find. Considering the track record of many mutual funds and market "gurus," you're likely to do at least as well as any "experts."

Buying the first share in order to enroll in a DRIP should kick-start your investing experience. Once you have a DRIP statement (and the tear-off portion for additional investments) in hand, it's easy to get going. Hundreds of companies even let you set up automatic debits from a bank account, so there's no excuse...even for the person who hates to write checks...for delaying the accumulation of wealth to meet your long-term goals.

If you have very little to start with, you can begin with one DRIP and add others periodically until you have a diversified portfolio. Otherwise, starting with a handful of basic industries and adding others later will do the trick. You can find out more at this site, and become enrolled in the DRIPs of your choice. Or call The Moneypaper at 1-800-388-9993.

 

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