What it means
Many investments, including mutual funds, exchange-traded funds and shares in listed companies, pay out income periodically. These payments are called distributions.
Instead of taking them as cash, an investor can choose to reinvest them, so that the money is used to buy more of the same investment on the payment date. The main benefit is compounding.
Each reinvested payment creates extra shares, and those shares earn future distributions of their own. Over many years the effect can be large, because growth builds on growth.
Reinvestment is usually automatic once the investor selects the option, and it often comes without a trading commission. Some plans allow the purchase of fractional shares, so every cent of the distribution is put to work.
The investor can usually change the choice and take cash at any time. There are tax and accounting points to note.
In many countries, a reinvested distribution is still treated as income in the year it is paid, so tax may be due even though no cash was received. Investors should also keep records of each reinvestment, because every purchase adds to the cost base used to calculate gains when the shares are sold.
A nuance is that reinvestment is not always the best choice. It increases the investor's exposure to a single holding, which may unbalance a diversified portfolio, and an investor who needs income to live on will want the cash.
The decision depends on goals and on whether the investment is still attractive at the new price. Cost is rarely the obstacle, but timing can be.
Reinvestment happens at the price on the payment date, which may be high or low, so the investor buys more units when prices are up as well as when they are down. Over many payments this tends to even out, a pattern similar to regular monthly investing.
In practice
Real-world examples.
Example
A young professional holds an index fund in her retirement account and chooses automatic reinvestment. Each quarter, the dividends buy additional units without any action from her. After twenty years, the extra units make up a significant share of her balance.
Example
A retired couple holds a dividend fund and takes distributions in cash to cover living costs. When they receive an unexpected inheritance, they switch to reinvestment for part of the holding. They plan to switch back when they need more income.
Example
A company treasury invests surplus funds in a money market fund that distributes income monthly. The treasurer sets the fund to reinvest, which keeps the cash fully invested. At year end the accountant records each reinvestment as an addition to the cost of the holding.
Formula
Calculation
New shares purchased = distribution amount / price per share on the reinvestment date
An investor owns 1,000 units of a fund that pays a distribution of $0.50 per unit, and the unit price on the payment date is $25.00. The total distribution is 1,000 x $0.50 = $500. The number of new units purchased is $500 / $25.00 = 20 units. The investor now holds 1,020 units, and the next distribution will be based on the larger holding.Case study
Seen in the real world.
Cobalt Lane Partners is an illustrative, fictional family business that invested $200,000 in a dividend-paying fund and chose to take the income in cash. The fund paid 4% a year, so the family received $8,000 each year and spent most of it.
The finance advisor compared this with reinvesting all distributions. Ignoring any change in the unit price, and assuming the 4% yield continued, the holding would grow to $200,000 x 1.04 x 1.04 x 1.04 x 1.04 x 1.04 = $243,331 after five years, against $200,000 plus $40,000 of cash received, or $240,000 in total for the cash route.
The difference of about $3,331 came from earning distributions on distributions, though the family decided to reinvest only half because they still needed some income. The illustrative lesson is that reinvestment helps most when the cash is not needed and the time horizon is long.
Watch out
Common mistakes.
- Assuming that reinvested distributions are tax-free, when they are usually taxed as income in the year they are paid.
- Failing to record each reinvestment, which makes it harder to work out gains or losses accurately when the holding is sold.
- Reinvesting automatically in a holding that has become too large a part of the portfolio, which increases concentration risk.
Questions
People also ask.
Can I stop reinvesting and take cash instead?
Yes. Most funds and brokers let investors change the setting at any time, and the change applies to future distributions.
Does reinvestment cost anything?
Often it is free of commission, but this depends on the fund or broker, so check the terms.
What is the difference between a distribution and a dividend?
A dividend is a payment from a company's profits, while a distribution is a broader term that covers dividends, interest and capital gains paid out by a fund.
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