The total return on an investment is made up of two components — price appreciation or depreciation (the gain or loss in market price), and income distributions (the value of dividends or interest payments).
Reinvesting your income distributions can be an important and easy way to potentially enhance your investment returns. Depending on their investment objective, mutual funds may receive interest or dividend payments on securities that they invest in. This income is distributed to shareholders as dividend income. Dividend payments may be made quarterly, biannually, or annually, providing a source of income to shareholders. This dividend distribution will also include any short-term gains from the fund’s sales of securities held one year or less.
Shareholders may choose to automatically reinvest their dividend distributions to purchase additional fund shares, or receive their distributions in cash. You may also choose to receive a portion of your distribution in cash and to reinvest the balance. If you are investing primarily for income, you may have designated all distributions to be paid in cash to fund your current living expenses. However, if your investment goal is long-term, reinvesting your distributions can potentially help your investment grow through compounding.
Reinvesting Distributions Offers Potential Benefits
Compounding is the ability of your reinvested dividends to earn additional returns over time. As your investment earnings build, the increase in the value of your investment can be substantial.
Reinvesting your dividend distributions also lets you potentially benefit from dollar cost averaging. Your dividend distributions will automatically buy more shares when the share price is lower and fewer when the share price is higher. As a result, your average cost per share over time may be less than the average price per share.
Keep in mind that dividend reinvestment may not be appropriate for all investors. For example, if you are retired or are investing for current income to meet cash needs, you may choose to receive all your dividend distributions in cash. Also, your dividend and capital gains distributions are taxable in the year received, even if they are reinvested. You may need to receive a portion of your dividend distributions in cash in order to pay any taxes due.
To make the most of the potential that dividend reinvestment can offer you can plan a dividend reinvestment strategy that caters to your personal needs. You may choose to reinvest your distributions in the same fund to increase your holdings in that investment or you may use your dividend distributions to buy shares of another fund. This may be an effective way to rebalance a portfolio that has become too concentrated in one investment.