Some investments provide a steady flow of income, such as stock dividends, bond coupon payments or property rentals. This article discusses how you can unlock the power of compounding (covered in more detail in a separate article) by reinvesting the income inflows from your investments.
Why reinvesting is key?
The occasional losses that arise from active trading in stocks may wipe out years of returns overnight. The best returns accrue to those who invest with a long-term perspective.
In our separate article on compounding, we show how investing over a longer period enhances the growth of your portfolio. Reinvesting your income can further boost this growth dramatically.
For example, assume that stock A pays an annual dividend of 3% of the share price and appreciates 5% annually. If you invest $1000 in stock A for 20 years, your portfolio would grow to $2,653 in value and you would have collected $992 in dividends. This is equivalent to a total return of 264.5% or 6.7% per annum.
If you reinvested the 3% dividends in more shares of stock A, your portfolio would grow to $4,595, equivalent to a total return of 359.5% or 7.9% per annum over 20 years. A 1.2% increase in annual returns may not appear much, but the growth in the final value of the portfolio would increase from 27% to 73% by reinvesting the dividends.
The chart below shows the effect of reinvesting 50% and 100% of the dividends, respectively, on the value of the portfolio over 20 years.
Issues to bear in mind
Investment decisions must consider the power of reinvestment within the context of your aims and wider portfolio. Income-generating assets may not be the best choice for all investors.
Also, the income from some assets may not be sustainable. For example, a company that does not generate profit may borrow money to maintain dividend payments. In this case, the dividend income to the investor will be offset by the loss of value over time. Reinvesting in such a company create no value.
Reinvestment is a tool, not a goal. The starting point is a clearly documented investment strategy that sets sensible parameters for various exposures to determine your needs for short-term income and long-term capital appreciation. Working with an advisor will help you create an intelligent approach to income-generating securities while mitigating risks. Please consult your advisor or contact The Family Office for any questions or assistance.
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