Reinvestment

Reinvestment Meaning

Reinvestment is the process of investing the returns received from investment in the form of dividends, interest, or any type of cash reward to purchase additional shares and reinvesting the gains; investors do not opt to check out cash benefit while they are reinvesting their profits in their portfolio.

Reinvestment

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Source: Reinvestment (wallstreetmojo.com)

Two Factors of Reinvestment

Let us discuss these two factors briefly:

#1 – Risk

  • There is always a risk of downside in any investment, and the investor won’t be able to reinvest at the current rate of return; in this case, the risk is exponentiated since the investment is multifold. For instance, Microsoft issues callable bondsCallable BondsA callable bond is a fixed-rate bond in which the issuing company has the right to repay the face value of the security at a pre-agreed-upon value prior to the bond's maturity. This right is exercised when the market interest rate falls.read more at the coupon rate of 6% per annum; however, the market interest rate reduces to 4%.
  • So, now the company can borrow money at a lower rate from the market by issuing another callable bond at 4%. If the investor had decided to reinvest at 6%, then the investor loses the opportunity to earn as the company repays the coupon and principal invested.
  • Reinvestment risk is comparatively low in non-callable bonds as the decision to call off the bonds is not dependent on the company, and investors have locked a fixed amount of funds with the company.
  • A Portfolio of mixed instruments helps to reduce the reinvestment risk, like investing in bonds with different maturities, bonds with different interest rates, and so on.
  • A fund manager assists in mitigating the risk and allocate the funds appropriately to the respective investments. However, there are always products in the market which provide ease of reinvestment like high yield funds such as Vanguard High Dividend Yield Fund (VHDYX), which gives high yields.
  • This fund performance is linked to the FTSE index and offers a proper reinvestment plan to the investors. However, market risk and falling yields are some risks that are totally unavoidable.

#2 – Interest Rate

  • Every other investment bear returns based on the interest rate, so the reinvestment rate is the rate at which money can be earned by investing in another fixed-income instrument other than the current one.
  • Anticipated interest rates for investment by any investor play a vital role; for instance, if the interest rate increases, the price of the bond tend to fall, and the individual loses the value of the principal and also makes less money than the current market rate, so a person faces interest rate risk for his reinvestment.

How to Calculate the Reinvestment Rate?

Difference Between Dividend Reinvestments vs Dividends

Broadly, when an investor invests in mutual funds, he gets to select which plan he opts to invest in, i.e., Dividend plan or Dividend Reinvestment plan, so let us see which plan is better from the return perspective.

So, it depends on the type of investor and the market so as to which plan will suit well as per the investment needs of the investor.

Conclusion

Reinvestment is a well-known phenomenon in the investment industry, where if certain risks are accounted for in a calculative way can yield exponential returns. Certain factors definitely need to be analyzed before opting for this plan; it should certainly be applied to the top-rated investment instruments where the credibility of the issuer can be banked.

This has been a guide to what is reinvestment and its meaning. Here we discuss how to calculate the reinvestment rate along with its two factors (risk and interest rate). You can more about finance from the following articles –