Reinvesting Interest and Dividends Earned on Investments for Continuous Financial Success
~ Friday, May 3, 2024 Blog Post ~
As a diligent, consistent, and aggressive saver and investor, my number one target is to secure my financial future. My strategy to achieve this important personal goal is reinvesting.
By reinvesting the interest and dividends I earned on my investments, I increase my overall returns, which can result in significant gains in my investments’ value over time. Reinvesting is a benefit that leads to compound interest or compounding.
This advantage of investing enables me to earn interest on previous interest payments. The returns I make on my investments can be in the form of interest payments, capital gains, or dividends.
Compounding’s effects equally apply to my investments in stock market shares and cash in commercial banks. With stock market shares, I earn dividends on my dividends.
I want to share these four relevant articles about the benefits of reinvesting and compounding.
Article #1: Turbocharge your returns by reinvesting dividends [From Investors’ Chronicle]
By Emma Agyemang, June 28, 2018
Reinvesting your dividends is a simple way to boost returns, but don’t forget to pay attention to costs and tax
Investment portfolios naturally see growth when share prices rise, but you can really enhance this by reinvesting the dividends you receive. This is because reinvesting dividends to buy more of the shares and investment trusts you own leads to compounding — where you earn returns on your returns.
Analysis by Fidelity International shows that an investor who put £100 a month in the FTSE All-Share index over the past 30 years and reinvested all dividends, would be sitting on a portfolio worth £140,585. Had they opted to take the dividends as income, rather than reinvesting, their portfolio would be worth almost half as much, at £70,923.
The more income you keep invested the greater your returns will be, even over shorter periods. For example, if you had followed the same approach of reinvesting dividends on an original investment in the FTSE All-Share over the past 10 years, you would have made £19,382 compared with £15,837 without reinvesting dividends.
Reinvesting your dividends will not be suitable for investors who need to take the money as income, of course. But investors looking to grow their pot over a long period should aim to utilise this simple strategy as it can help build wealth. Given interest rates are still low by historic standards and cash savings and government bonds offer low returns, reinvesting dividends is more fruitful as long as you are willing to add to your equity portfolio.
“While growth-focused investors sometimes treat dividends as the icing on the cake, they can be a large driver of investment returns when reinvested,” adds Tom Stevenson, investment director at Fidelity Personal Investing. “Indeed, over very long periods, a lot of the gains from investing in the stock market can be attributed to the reinvestment of dividends.”
Reinvesting dividends is one of the easiest ways to expose yourself to the power of compounding — particularly if you have a long-term investment horizon. Compounding is arguably the most beneficial factor of investing when it comes to growing wealth — the more you keep in markets for longer, the more you can get out. Research from Interactive Investor shows what happens if annual investment returns were 0.5 percentage points higher over the long term, highlighting that reinvesting dividends back into the market — and therefore increasing your returns — and keeping it invested for a long period can boost your pot substantially.
It found a return of 5.5 per cent a year on an initial investment of £1,000, compared with 5 per cent a year, resulted in a portfolio of £14,542 compared with £11,467 after 50 years. There were also gains over shorter periods of time, but pension freedoms have resulted in investors staying in the market during retirement, so 50 years is a realistic investment time horizon.
Ways to use dividend reinvestment to boost returns
There are two main ways to harness the power of compounding through reinvesting your dividends. The first is to invest a lump sum, and make sure you reinvest any dividends as they arise throughout the year. If you are using a tax-efficient wrapper such as an individual savings account (Isa), for example, this would mean investing as much of the £20,000 annual Isa allowance as you can afford as close to the start of the tax year as possible to secure maximum dividend payments.
Of course, not everybody can maximise their Isa allowance at the start of the tax year. So, a second way to benefit from dividend reinvestment is by regularly adding to your holdings through a regular investment plan and automatically reinvesting any dividends that arise. Regular investing plans are widely available across platforms. They allow you to purchase shares and investment trusts at a reduced dealing commission of £1-£2 per trade, and invest as little as £20 a month. Combining dividend reinvestment with a regular investing plan can help smooth out market volatility. Your funds will benefit from an effect known as pound cost averaging — when markets go up and are more expensive, your regular fixed amount plus any reinvested dividends will buy fewer shares. But when markets fall and are cheaper, your money will buy more shares.
“This method tends to be particularly useful during volatile markets, such as we saw during the financial crisis and have seen to a certain extent so far this year,” says Adrian Lowcock, investment director at Architas.
Disadvantages of dividend reinvestment
While reinvesting your dividends offers many advantages, there are some risks you need to consider. Firstly, there is always the risk of not paying attention to the dividends companies offer and being unaware that a company has cut or cancelled its dividend. Not paying attention to dividend policies also means you could miss wider fundamental issues in your investments, according to Nick Kirrage, a fund manager at Schroders.
“Some companies borrow money to pay dividends, to keep investors happy. This is not always a sustainable approach. Borrowing money to pay a dividend could be a symptom of a company with a weak balance sheet,” he adds.
To compensate for this potential risk, investors need to properly research the companies they invest in. You should also make sure you have a well-diversified portfolio, so that a cancellation or reduction in dividends at one company does not have too large an impact on your ability to reinvest and grow your wealth.
The reinvesting of dividends may also skew your portfolio in a way you did not intend. You might not want to add more to a holding depending on the company’s prospects, or because the company’s share price has done very well and therefore the holding is now a very large part of your portfolio. So make sure you regularly review your reinvestments and think about the company’s prospects.
Meanwhile reinvesting dividends does not mitigate any tax you are liable for on the dividend. This is one of the reasons why it is a good idea to hold any income-generating assets in a tax-efficient wrapper such as an Isa or self-invested personal pension (Sipp). As if the investment is held in an Isa or pension wrapper, there is no tax to pay on the dividends or on realising gains by selling units. But if you hold assets outside an Isa or pension wrapper, any dividends are subject to tax, whether these are paid out or reinvested. In the current tax year, everybody has a dividend allowance of £2,000. But any dividends generated above this amount, which are not held in a tax-efficient wrapper, will be liable for tax at 7.5 per cent if you are a basic-rate taxpayer, 32.5 per cent if you are a higher-rate taxpayer or 38.1 per cent if you are an additional-rate taxpayer.
Costs are another major factor to consider as most platforms and brokers charge investors to open dividend reinvestment plans (Drips). These are the most common type of dividend reinvestment and they use dividend cash to buy new shares in the market. However, there is also another option called Scrip dividend schemes, which allow shareholders to receive newly issued company shares, equivalent to the value of any cash dividend. Scrips have the advantage of not incurring stamp duty or platform trading fees, but few providers now offer them. Those that still do include: Barclays Smart Investor, Equiniti Shareview and HSBC InvestDirect. (see table below)
In terms of Drip providers, there are a few providers who allow you to reinvest dividends at no additional cost to their existing platform fees. One example is Barclays Smart Investor. Its platform fee is 0.2 per cent on the value of funds, 0.1 per cent per year on other assets, with a minimum fee of £4 and maximum of £125 a month. Dividend reinvestment is also available at no additional charge at Bestinvest, although this service is only available for funds, rather than shares or investment trusts. Fidelity Personal Investing also does not charge to reinvest dividends in funds but does for shares and investment trusts.
Other lower-charging Drip providers include Interactive Investor, which charges £1 per trade for dividend reinvestment, while the minimum dividend value required for reinvestment is £10. Selftrade charges £1.50 per trade, with no minimum investment needed, although the value of the dividend cash must be enough to purchase at least one share. The Share Centre charges 0.5 per cent per trade on dividend reinvestment, with a minimum cost of £1 and investment level of £10.
Although the platforms charge involved with reinvesting dividends may not seem like much, it can be inefficient to reinvest small amounts of money. If the dividend payout comes to £10, and you pay £1 to reinvest it, the cost equals 10 per cent of your original return. So, it can be better to build dividends up to a larger sum before you invest them. To make it worthwhile, investors should aim to spend no more than 5 per cent of your dividends on the cost of reinvesting.
Source:
Article #2: Reinvesting: What you Need to Know [From NerdWallet]
By Daniel Liberto, January 29, 2021
Reinvesting means using dividends, interest or other forms of income to buy more shares. For some this holds advantages, but it might not be right for others.
Investments don’t just make money when sold at a profit. Many of them, including shares, bonds and real estate investment trusts (REITs), also pay a regular income. When this is the case, investors have two options: pocket the cash or reinvest it, either in the same investment or another one.
What is reinvesting?
Reinvesting is when you use dividends, interest or other forms of income an investment generates to purchase additional shares of ownership.
The term can apply to pumping returns into any investment of your choice. Predominantly, though, when investors talk about reinvesting they are referring to the automated process, offered by brokers, of allocating income earned back into the investment that distributed it.
Why do investors reinvest income?
For many investors, any time income is paid out the proceeds are immediately used to top-up holdings, resulting in you gradually owning larger stakes that could entitle you to an even bigger slice of dividends or interest in the future.
Why do people not reinvest income?
Reinvesting might make sense if you don’t need the money now and are saving for a financial goal later on in life. Should, by contrast, you require a bit of extra income to supplement your salary or pension, you may choose to take the income.
There are other reasons, too, why reinvesting isn’t everyone’s cup of tea. For all its potential merits, this strategy isn’t flawless and comes with risks.
Reinvesting income risks
Automatically reinvesting income into the same entities that pay it out has proved to be one of the greatest ways for investors to build wealth over the long term. There are no guarantees, though.
Just because an investment rewards you with periodic payments, that doesn’t necessarily mean you should immediately increase your stake in it. Over the years, the subject’s financial strength, prospects and valuation may change relative to other options in the market.
Reinvesting on autopilot can also lead certain holdings to dominate portfolios, eroding diversification benefits and increasing the risk of becoming too reliant on the fate of a handful of investments.
There are costs to consider, too: platforms might charge for this privilege and reinvesting doesn’t excuse you from paying tax on any income received.
How to reinvest income
When choosing investment funds, investors are usually presented with an option to buy either “accumulation” or “income” units — acc or inc for short. The former uses all income proceeds to purchase more units in the fund, while the latter credits payments to your account for you to do with as you please.
For individual shares, it’s less straightforward. You’ll need to specify that you want dividends to be reinvested, normally by signing up to a dividend reinvestment plan (DRIP). Check with your platform provider before proceeding. Brokers may charge for setting up this service and often apply fees each time a reinvesting transaction occurs.
WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you.
Source:
https://www.nerdwallet.com/uk/investing/reinvesting/
Article #3: The Benefits of Reinvesting your Returns [From Scrambleup]
By Scrambleup, August 4, 2023
As people who care about our financial well-being, we all want our money to grow and maintain its purchasing power over time. The key to maximizing savings and achieving long-term financial security lies in the concept of reinvestment. It involves using the returns earned from your investments, such as dividends or interest, to generate additional average income or growth. This simple yet powerful strategy is based on the principle of compounding, where your returns are reinvested back into the fund to generate additional future returns. Let’s explore why reinvesting is essential and how it can help your wealth grow exponentially over the long term.
As people who care about our financial well-being, we all want our money to grow and maintain its purchasing power over time. The key to maximizing savings and achieving long-term financial security lies in the concept of reinvestment. It involves using the returns earned from your investments, such as dividends or interest, to generate additional average income or growth. This simple yet powerful strategy is based on the principle of compounding, where your returns are reinvested back into the fund to generate additional future returns. Let’s explore why reinvesting is essential and how it can help your wealth grow exponentially over the long term.
The Power of Compounding
At the heart of reinvestment is the power of compounding. This phenomenon occurs when your investment returns generate even more returns over time. As you reinvest your earnings, the interest is added to the principal, resulting in further growth. By continuously reinvesting your earnings, you allow the interest to accumulate, accelerating the process of compounding.
The Time Factor
The most important variable in compounding success is time. The longer your investment stays in the market, the more money you can accumulate. When you apply the interest rate on your initial capital multiple times, including the returns generated by that capital, your profits grow exponentially. The effects of reinvestment may seem modest in the early stages, but the true power lies in the long-term benefits. The larger your investment base becomes each year, the higher your annual returns will be.
The Advantage of Starting Early
To make the most of the compounding effect of reinvestment, it is important to start investing early. By making small investments early in life, you give your savings plenty of time to grow dramatically over the years. The earlier you start investing, the longer your money can compound, allowing you to accumulate more wealth in the long run.
Bottom Line
Reinvesting your earnings is a powerful strategy that can significantly impact your long-term financial success. Starting early and consistently reinvesting your returns can lead to rapid growth in your savings. Remember, time is the key to maximizing the benefits of compounding, so start investing today and let your money grow for as long as possible.
Source:
https://scrambleup.com/blog/benefits-reinvesting-your-returns
Article #4: Reinvestment: Definition, Examples, and Risks [From Investopedia]
By James Chen, April 3, 2024
What Is Reinvestment?
Reinvestment is the practice of using dividends, interest, or any other form of income distribution earned in an investment to purchase additional shares or units, rather than receiving the distributions in cash.
KEY TAKEAWAYS
- Reinvestment is when income distributions received from an investment are plowed back into that investment instead of receiving cash.
- Reinvestment works by using dividends received to purchase more of that stock, or interest payments received to buy more of that bond.
- Dividend reinvestment programs (DRIPs) automate the process of stock accumulation from dividend flows.
- Fixed income and callable securities open up the potential for reinvestment risk, where the new investments to be made with distributions are less opportune.
Understanding Reinvestments
Reinvestment is a great way to significantly increase the value of a stock, mutual fund, or exchange-traded fund (ETF) investment over time. It is facilitated when an investor uses proceeds distributed from the ownership of an investment to buy more shares or units of the same investment.
Proceeds can include any distribution paid out from the investment including dividends, interest, or any other form of distribution associated with the investment’s ownership. If not reinvested these funds would be paid to the investor as cash. Social enterprises mainly reinvest back into their own operations.1
European Commission. “Creating a Favorable Climate for Social Enterprises: Key Stakeholders in the Social Economy and Innovation,” Pages 2 & 3. Accessed Jan. 28, 2020.
Dividend Reinvestment
Dividend reinvestment plans, also known as DRIPs, allow investors the opportunity to efficiently reinvest proceeds in additional shares of the investment. Issuers of an investment can structure their investment offerings to include dividend reinvestment programs.
Corporations commonly offer dividend reinvestment plans. Other types of companies with public offerings such as master limited partnerships and real estate investment trusts can also institute dividend reinvestment plans. Fund companies paying distributions also decide whether or not they will allow dividend reinvestment.
Investors investing in a stock that is traded on a public exchange will typically enter into a dividend reinvestment plan through their brokerage platform elections. When buying an investment through a brokerage platform, an investor has the option to reinvest dividends if dividend reinvestment is enabled for the investment.
If dividend reinvestment is offered, an investor can typically change their election with their brokerage firm any time during the duration of their investment. Reinvestment is typically offered with no commission and allows the investors to buy fractional shares of a security with the distributed proceeds.
Income Investments
Reinvestment is an important consideration for all types of investments and can specifically add to investment gains for income investors. Numerous income-focused investments are offered for both debt and equity investments. The Vanguard High Dividend Yield Fund (VHDYX) is one of the broad market’s top dividend mutual funds. It is an index fund that seeks to track the FTSE High Dividend Yield Index.2 It offers investors the opportunity to reinvest all dividends in fractional shares of the fund.
Income investors choosing reinvestment should be sure to consider taxes when reinvesting paid distributions. Investors are still required to pay taxes on distributions regardless of whether or not they are reinvested.3
Important: Zero-coupon bonds are the only fixed-income instrument to have no investment risk since they issue no coupon payments.
Special Considerations: Reinvestment Risk
Although there are several advantages to reinvesting dividends, there are times when the risks outweigh the rewards. For example, consider the reinvestment rate, or the amount of interest that can be earned when money is taken out of one fixed-income investment and put into another. Essentially, the reinvestment rate is the amount of interest the investor could earn if they purchased a new bond while holding a callable bond called due because of an interest rate decline.
If an investor is reinvesting proceeds, they may need to consider reinvestment risk. Reinvestment risk is the chance that an investor will be unable to reinvest cash flows (e.g., coupon payments) at a rate comparable to the current investment’s rate of return. Reinvestment risk can arise across all types of investments.
Generally, reinvestment risk is the risk that an investor could be earning a greater return by investing proceeds in a higher returning investment. This is commonly considered with fixed income security reinvestment since these investments have consistently stated rates of return that vary with new issuances and market rate changes. Prior to a significant investment distribution, investors should consider their current allocations and broad market investment options.
For example, an investor buys a 10-year $100,000 Treasury note with an interest rate of 6%. The investor expects to earn $6,000 per year from the security. However, at the end of the term, interest rates are 4%. If the investor buys another 10-year $100,000 Treasury note, they will earn $4,000 annually rather than $6,000. Also, if interest rates subsequently increase and they sell the note before its maturity date, they lose part of the principal.
Sources and references:
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