What is... | February 6, 2012

What is dividend reinvestment?

Investors who hold shares in companies can make money two ways. One is selling after a rise in the value of their shares and the other is getting dividend payments.

How investors use dividends can make a big difference in how much money they make – particularly if they can overcome the attraction of short-term gains and keep their financial future as a focus.
Company news often focuses on rises or falls in the share price, overlooking the importance of the dividend payment. However investors should remember that re-investing their dividend payments back into the stock of the company can be a powerful force for generating wealth.

Paying dividends
Many companies listed on share markets pay cash dividends to investors, sometimes twice a year. Investors can choose to take the money or to reinvest it in the company’s shares. Dividend reinvestment plans (DRIP) that automatically reinvest payments are offered by some companies.
Studies show that dividend reinvestment can make more of a difference financially than gains in the capital value of shares. The influential book Triumph of the Optimists found that over a 101-year period, a portfolio of shares with dividends reinvested would have generated 83 times as much wealth as relying on capital gains alone.

Compound medicine
The reason for large gains is similar to the way compound interest leads to growth for cash when the interest is reinvested with the balance.
Dividend reinvestment has twice that power. Automatically buying more shares increases future dividend payments and also increases the number of shares held. Investors can further compound the effect by making a commitment to regular saving.

Look ahead
When money is taken out of long-term investments early, be aware that this will also cut reinvestment returns.
A problem is that people tend to value smaller immediate returns over large long-term rewards. This is known as “hyperbolic discounting” – the preference of many to go for the quick win.
One way households can put the value of dividend reinvesting into context is to imagine what their financial needs will be in a few years’ time. Seeing an older version of yourself may make the implications of financial choices more vivid – and has been shown to boost retirement savings. But imagining life in the future was not common amongst respondents to an eZonomics poll.

Divide and thrive
It’s a good idea to have liquid funds for “rainy day” emergencies but in addition build a long-term savings pot. Commitment contracts or investments that make it difficult to withdraw money early can be good ways to encourage reinvestment and curb temptation to dip into funds.
After all, the research shows that a little restraint in the short-term can pay huge amounts over time.

InvestingSharesGoal settingHyperbolic discounting

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics