Automatic Reinvestment Plan

Investing in mutual funds includes various options. There is a growth plan, dividend plan and dividend reinvestment plan. This article describes the intricacies of an automatic reinvestment plan in detail.

An Automatic Reinvestment Plan?

An automatic reinvestment plan automatically reinvests the profits from capital gains and dividends back into your portfolio instead of depositing them back into your savings account. In an automatic reinvestment plan, investors benefit from the power of compounding. The most common example of an automatic reinvestment plan is a dividend reinvestment plan (DRIP).

What is a Dividend Reinvestment Plan (DRIP)?

In DRIP, investors use the cash dividend from their investment portfolio to buy more of the underlying investment.

For instance, say Ms J holds 10 shares of Company C. The company has recently declared a dividend of INR 10 each. Ms J had opted for the dividend reinvestment plan; hence, she does not receive the dividend amounting to INR 100. The shares were trading at INR 50 then, she received two additional shares of Company C instead. The following year, Ms J would receive dividends on her total shareholding of 10+2=12 shares. This continues until the investor sells the holding or puts off the dividend reinvestment plan.

Disadvantages of an Automatic Reinvestment Plan

An automatic reinvestment plan is akin to putting all eggs in one basket. The plan reinvests the portfolio returns in the same fund. This practice may lead to a lack of portfolio diversification and an imbalance in the investor’s target portfolio allocation. It is also not suitable for investors who expect a regular cash payout from their investments.

Compound Interest in an Automatic Reinvestment Plan

Compounding or ‘earning interest on interest’ can drastically increase the returns on investment.

A= P(1+r/n {)} ^ {nt}

A = Final amount

P = Initial principal balance

r = Rate of interest

n = No. of times interest is paid

t = Periods elapsed

For example, investing INR 10,000 at 10% simple interest will give the investor INR 1,000 in interest every year. This is how investing the same sum @ 10% compounding interest will boost the returns manifold.

After the first year, the investor receives INR 1,000 as interest payment. This amount is reinvested at the same rate. For the second year, the interest is calculated at INR 11,000, which comes to INR 1,100. Likewise, in the third year, interest is calculated at INR 12,100. After 40 years, the balance amount in the investor’s portfolio comes out to INR 174,494. Compare this to the balance in the portfolio generating returns based on simple interest–a paltry INR 40,000.

Reinvesting a mutual fund's gains adds more shares to an investor’s portfolio. Compound interest accumulates over time, and the chain of purchasing additional shares continues, thereby increasing your initial investment. By adding the returns from the mutual fund back into the portfolio, the mutual fund's worth increases exponentially.