Should You Reinvest the Income from Your Bond Funds?
The Importance of Reinvesting the Income from Your Bond Funds
Most investors have undoubtedly heard the advice to “invest for the long term,” but that’s only half of the equation for building wealth over time. The true key to long-term wealth accumulation lies in the reinvestment of dividends and capital gains.
Let’s take a look at why this is. Say an investor buys 1,000 shares of a bond mutual fund with a share price of $10 and a yield of 4%.
For the sake of clarity, we’ll assume that the fund’s share price and yield don’t change. The investor receives $400 a year in income from the fund, or $33.33 each month.
If the investor chooses to take the income in the form of a check each month, he or she will have that $33.33 available to spend. However, the investor will also maintain his or her original 1,000 shares with no opportunity to benefit from the power of compounding.
On the other hand, consider what happens to the investor’s account when this income is reinvested. The first month, that $33.33 buys the investor new shares. Instead of owning 1,000, he or she owns 1,003.33. The next month, that same 4% yield brings in $33.44, which again is invested back into the fund. Each month, the amount of income receives grows by a little bit, and each time it buys a few more shares than it did the month before.
This may not sound like much. After all, what good is that extra 11 cents in the first month? But over time, the extra cash from reinvestment can really add up:
The math continues in the same fashion no matter how far you extend the time period, illustrating that the investor whose chose to reinvest his or her income back into the fund comes out far ahead of the person who chose to take the income in cash.
Dollar Cost Averaging
Having said all of this, it’s important to keep in mind that the process of reinvestment doesn’t work quite as cleanly in real life as it did in the example above. Mutual funds (other than money market funds, which have a stable $1.00 share price) experience share price fluctuation over time. As a result, the principal in the example above wouldn’t be exactly $14,858 – it could be higher or lower depending on market conditions. There is an advantage to this, however: if the share price of the fund drops, the investor can buy more shares when the monthly dividend is reinvested. Conversely, if the share price goes up, the investor buys fewer shares at the more expensive price. This is called “dollar cost averaging,” and it forces the discipline of buying high and selling low.
It should be said that many people, especially those in retirement, need to take the income from their investments to supplement Social Security, their pensions, or other sources of retirement income. But for those who don’t have the immediate need for cash in hand, reinvestment is the wiser course.
Learn more about bond basics at Bonds 101.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.
Most investors have undoubtedly heard the advice to “invest for the long term,” but that’s only half of the equation for building wealth over time. The true key to long-term wealth accumulation lies in the reinvestment of dividends and capital gains.
Let’s take a look at why this is. Say an investor buys 1,000 shares of a bond mutual fund with a share price of $10 and a yield of 4%.
For the sake of clarity, we’ll assume that the fund’s share price and yield don’t change. The investor receives $400 a year in income from the fund, or $33.33 each month.
If the investor chooses to take the income in the form of a check each month, he or she will have that $33.33 available to spend. However, the investor will also maintain his or her original 1,000 shares with no opportunity to benefit from the power of compounding.
On the other hand, consider what happens to the investor’s account when this income is reinvested. The first month, that $33.33 buys the investor new shares. Instead of owning 1,000, he or she owns 1,003.33. The next month, that same 4% yield brings in $33.44, which again is invested back into the fund. Each month, the amount of income receives grows by a little bit, and each time it buys a few more shares than it did the month before.
This may not sound like much. After all, what good is that extra 11 cents in the first month? But over time, the extra cash from reinvestment can really add up:
- By the end of the first year, for example, the investor will have 1,037.28 shares (worth $10,372) and his or her monthly income will have risen to $34.60.
- At the end of Year 5, the account will have grown to 1216.94 shares ($12,169.40), and the same 4% yield will bring in $40.60.
- After 10 years, the investor would have 1485.88 shares ($14,858.80) with monthly income of $49.50.
The math continues in the same fashion no matter how far you extend the time period, illustrating that the investor whose chose to reinvest his or her income back into the fund comes out far ahead of the person who chose to take the income in cash.
Dollar Cost Averaging
Having said all of this, it’s important to keep in mind that the process of reinvestment doesn’t work quite as cleanly in real life as it did in the example above. Mutual funds (other than money market funds, which have a stable $1.00 share price) experience share price fluctuation over time. As a result, the principal in the example above wouldn’t be exactly $14,858 – it could be higher or lower depending on market conditions. There is an advantage to this, however: if the share price of the fund drops, the investor can buy more shares when the monthly dividend is reinvested. Conversely, if the share price goes up, the investor buys fewer shares at the more expensive price. This is called “dollar cost averaging,” and it forces the discipline of buying high and selling low.
It should be said that many people, especially those in retirement, need to take the income from their investments to supplement Social Security, their pensions, or other sources of retirement income. But for those who don’t have the immediate need for cash in hand, reinvestment is the wiser course.
Learn more about bond basics at Bonds 101.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.
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