Reinvesting: What you Need to Know
Reinvesting means using dividends, interest or other forms of income to buy more shares. For some this holds advantages, but it might not be right for others.
Investments don’t just make money when sold at a profit. Many of them, including shares, bonds and real estate investment trusts (REITs), also pay a regular income. When this is the case, investors have two options: pocket the cash or reinvest it, either in the same investment or another one.
What is reinvesting?
Reinvesting is when you use dividends, interest or other forms of income an investment generates to purchase additional shares of ownership.
» MORE: About dividends
The term can apply to pumping returns into any investment of your choice. Predominantly, though, when investors talk about reinvesting they are referring to the automated process, offered by brokers, of allocating income earned back into the investment that distributed it.
Why do investors reinvest income?
For many investors, any time income is paid out the proceeds are immediately used to top-up holdings, resulting in you gradually owning larger stakes that could entitle you to an even bigger slice of dividends or interest in the future.
Why do people not reinvest income?
Reinvesting might make sense if you don’t need the money now and are saving for a financial goal later on in life. Should, by contrast, you require a bit of extra income to supplement your salary or pension, you may choose to take the income.
There are other reasons, too, why reinvesting isn’t everyone’s cup of tea. For all its potential merits, this strategy isn’t flawless and comes with risks.
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Reinvesting income risks
Automatically reinvesting income into the same entities that pay it out has proved to be one of the greatest ways for investors to build wealth over the long term. There are no guarantees, though.
Just because an investment rewards you with periodic payments, that doesn’t necessarily mean you should immediately increase your stake in it. Over the years, the subject’s financial strength, prospects and valuation may change relative to other options in the market.
Reinvesting on autopilot can also lead certain holdings to dominate portfolios, eroding diversification benefits and increasing the risk of becoming too reliant on the fate of a handful of investments.
There are costs to consider, too: platforms might charge for this privilege and reinvesting doesn’t excuse you from paying tax on any income received.
» MORE: Dividend tax
How to reinvest income
When choosing investment funds, investors are usually presented with an option to buy either “accumulation” or “income” units – acc or inc for short. The former uses all income proceeds to purchase more units in the fund, while the latter credits payments to your account for you to do with as you please.
For individual shares, it’s less straightforward. You’ll need to specify that you want dividends to be reinvested, normally by signing up to a dividend reinvestment plan (DRIP). Check with your platform provider before proceeding. Brokers may charge for setting up this service and often apply fees each time a reinvesting transaction occurs.
WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you.
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Daniel is a freelance finance journalist. He has written and edited news, deeper analysis features, and opinion pieces for the Financial Times, Investopedia and the Investors Chronicle. Read more