The Power of Reinvestment
Reinvestment is the practice of using dividends, interest, or any other form of income distribution earned from an investment to purchase additional shares or units, rather than receiving the distributions in cash.
Key Takeaways
- Reinvestment involves plowing income distributions back into the investment instead of taking the cash.
- It is the process of purchasing more stock with dividends or buying more bonds with interest payments.
- Dividend reinvestment programs (DRIPs) automate recurrent accumulations in stock from dividend flows.
- Fixed-income securities carry reinvestment risk as new investments made with distributions may be less opportune.
Understanding Reinvestments
Reinvestment significantly amplifies the value of stock, mutual fund, or exchange-traded fund (ETF) investments over time. It works by taking proceeds from income distributions like dividends and interest to buy additional shares or units of the same investment. If not reinvested, these proceeds would be received as cash payouts.
Dividend Reinvestment
Dividend reinvestment plans, commonly known as DRIPs, enable investors to reinvest proceeds in additional shares of the investment. Corporations, including master limited partnerships and real estate investment trusts, may structure their investment offerings to include DRIPs.
Through a brokerage platform, investors in publicly traded stocks can opt to reinvest dividends. This election can be changed anytime during the investment period, typically at no commission and may allow for purchasing fractional shares of a security with the proceeds.
Income Investments
Reinvestment is pivotal for income investors focusing on nuanced gains. Take, for instance, the Vanguard High Dividend Yield Fund (VHDYX), a top dividend mutual fund that tracks the FTSE High Dividend Yield Index. It allows investors to reinvest dividends in fractional shares, marginally elevating their stake over time.
Income-focused investors should note tax implications even when opting for reinvestment, as taxes apply to distributed earnings regardless. Unique to zero-coupon bonds, these fixed-income instruments avoid reinvestment risk since they do not issue coupon payments.
Special Considerations: Reinvestment Risk
While reinvestment, especially of dividends, carries unique advantages, risks should not be ignored. One major risk involves interest rates and bond performance. An investor holding a callable bond might find that reinvestment offers lower returns if interest rates decrease and the bond is called.
Reinvestment risk, magnified in fixed-income securities, means the investor might secure a lesser return on available higher-yield reinvestment opportunities. When an impending significant investment distribution looms, assessing current allocations and the broader market can be advantageous.
For instance, a 10-year $100,000 Treasury note with a 6% interest rate generates $6,000 annually. At the 10-year mark, if interest rates dive to 4%, a reinvesting investor only nets $4,000 yearly. Additionally, selling the note before maturity amidst climbing interest rates risks principal depreciation.
Related Terms: dividend, stock, mutual fund, exchange-traded fund, fixed income, callable bond.
References
- European Commission. “Creating a Favorable Climate for Social Enterprises: Key Stakeholders in the Social Economy and Innovation”, Pages 2 & 3.
- Vanguard. “Vanguard High Dividend Yield Index Fund Investor Shares (VHDYX)”.
- Internal Revenue Service. “Publication 550: Investment Income and Expenses”, Page 20.
