Most investors have surely heard the advice to “invest for the long term,” but this is only part of the equation for building wealth over time. The key to accumulating wealth over the long term lies in reinvesting profits and capital gains.
The Power of Accumulation
Let’s take a look at why this is the case. Suppose an investor buys 1,000 shares of a bond mutual fund at a share price of $10 and a yield of 4%. For clarity, we will assume that the fund’s share price and yield remain unchanged. The investor receives $400 annually as income from the fund, or $33.33 monthly.
If the investor chooses to take the income in the form of a monthly check, they will have that $33.33 available to spend. However, the investor will also retain the original 1,000 shares without the opportunity to benefit from the power of accumulation.
On the other hand, let’s look at what happens to the investor’s account when this income is reinvested. In the first month, that $33.33 buys a new share for the investor. Instead of owning 1,000 shares, they own 1,003.33 shares. In the following month, the same 4% yield brings in $33.44, which is reinvested in the fund. Each month, the amount of income received grows slightly, and each time, it buys a larger number of shares compared to the previous month.
This may not seem significant. After all, what’s the benefit of that extra 11 cents in the first month? But over time, the additional money derived from reinvestment can accumulate: at the end of the first year, for example, the investor will have 1,037.28 shares (worth $10,372.80), and their monthly income will have risen to $34.58. By the end of year five, the account will have grown to 1,216.94 shares (worth $12,169.40), generating the same 4% yield of $40.56 monthly. After 10 years, the investor will have 1,485.88 shares (worth $14,858.80), with a monthly income of $49.53.
The math continues this way regardless of how far out the time period is extended, illustrating that an investor who chooses to reinvest their income in the fund achieves much better results than one who takes their income in cash.
Dollar-Cost Averaging
It’s also important to keep in mind that the process of reinvestment does not operate as smoothly in real life as it does in the example above. Generally, mutual funds offer less volatility and risk than individual stocks. However, even cautiously managed funds experience fluctuations in stock prices over time. As a result, the capital in the above example may not exactly be $14,858.80 – it could be higher or lower depending on market conditions.
However, there is one advantage to this: if the fund’s share price declines, the investor who reinvests their dividends automatically buys more shares. Conversely, when the share price rises, the investor who reinvests their dividends buys fewer shares. This process is known as “dollar-cost averaging,” which involves buying shares at high prices and selling them at low prices automatically.
It should be noted that many people, especially those in retirement, need to take income from their investments to supplement Social Security and their pensions or other retirement income sources. But if you don’t have an immediate need for cash in hand, reinvestment is always the better option. Over the long haul, it’s the best way to build wealth.
Main Takeaways
Reinvesting profits and capital gains is a fundamental part of building wealth. When investors reinvest income, they benefit from the power of accumulation to grow their investments and achieve future profits. Generally, investors who choose to reinvest their dividends earn more over time compared to those who take their profits in cash. No investment comes without risks. While mutual funds offer less volatility than investing in individual stocks, they can still lose value even in cautiously managed funds.
Source:
https://www.thebalancemoney.com/should-you-reinvest-the-income-from-your-bond-funds-416963
Leave a Reply