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 is mainly used by investors to increase the value of the portfolio by concentrating all the funds into one particular investment; in the case where the price of security surges, the value of the portfolio shoots up accordingly.
- Reinvestment can also be used in the context where a business is reinvesting the profits to further expand the company or investing in any technological advancements from a long-term perspective.
- Reinvestment can be done with any type of assets like stocks, mutual funds, bonds, ETF, or any instrument which gives periodic returns, and the proceeds can be used to reinvest.
- There are other factors involved in reinvestment risk and interest rate risk when the money is invested back in buying the same securities.
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 bonds 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?
- The reinvested rate calculates the proportion of the company’s net income that is earned by reinvesting the money in the portfolio.
- Amazon, as a company, is a perfect example here, who was continuously reinvesting the profits into the business to expand its operations in the year 2000. Amazon was continuously booking losses for several years from its inception since it was concentrating on sustaining and growing.
- Let us assume the Net Income of Amazon in the year 2000 was $100,000, and capital expenditures were around $70,000. So, the reinvestment rate for Amazon for the year 200 will be Capital Expenditure / Net Income i.e. 70,000 / 100,000 = 70%. It means that Amazon was reinvesting 70% of its profits in the business.
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.
- Dividend Plan – In this plan, an investor gets all his dividends in cash as per the fund units he owns, and accordingly, the Net asset value of the fund goes down proportionately with the amount paid for the dividend. So, an investor whose daily values NAV of the portfolio notices a significant drop in the value of their portfolio.
- Dividend Reinvestment Plan – This is a hybrid plan where the dividend units are invested back into the same fund; this not only increases the NAV of the fund but also increases the compounded rate of return from the fund.
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.
- Also, it depends on the type of investment you are looking for that is short term or long term. If the investment is short-term, then it is always beneficial to opt for cash dividends to enjoy the cash reward; however, if the investment is long-term, it’s advisable to go for a reinvestment plan.
- This plan will help you to earn a handsome return rate over a certain period, and also the money invested will grow at a compounded rate utilizing the number of years of the investment.
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 –