What Is an Automatic Reinvestment Plan?
An automatic reinvestment plan (ARP) is a plan that automatically reinvests capital gains or dividends back into a portfolio. This is commonly found in dividend reinvestment plans (DRIPs). In the case of a mutual fund, for example, capital gains and fees produced by the fund would be used to automatically purchase more shares instead of being distributed to the investor as cash.
An ARP should not be confused with an automatic investment plan (AIP), which is a program that allows investors to contribute new money to an investment account at regular intervals to be invested in a pre-set strategy or portfolio.
- An automatic reinvestment plan takes investment gains and uses them to purchase additional assets.
- Mutual funds may reinvest capital gains and other distributions back into the portfolio rather than pay out cash to fund holders.
- Dividend reinvestment plans (DRIPs) automatically use dividend payments to purchase additional shares.
Understanding Automatic Reinvestment Plans
An automatic reinvestment plan helps an investor take advantage of the compounding effect to produce further gains. Over a period of years, the added value produced by automatic reinvestment can turn out to be worth a substantial sum.
An example of a type of automatic reinvestment plan is a dividend reinvestment plan (DRIP), which is a program that allows investors to reinvest their cash dividends into additional shares or fractional shares of the underlying stock on the dividend payment date. A DRIP can be set up as an automatic reinvestment arrangement set up through a brokerage or investment company, but it can also be instantiated directly by a publicly traded corporation to its existing shareholders. Around 650 companies and 500 closed-end funds currently do so. Share purchases involving DRIPs are most often commission-free.
Compound Interest in an Automatic Reinvestment Plan
One of the benefits of reinvesting gains is compounding. Compound interest (or compounding interest) is interest calculated on the initial principal and on the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as “interest on interest” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount.
Compound interest is calculated by multiplying the principal amount by one plus the annual interest rate raised to the number of compound periods minus one. The total initial amount of the loan is then subtracted from the resulting value.
Opting to reinvest a mutual fund's gains results in purchasing more shares of the fund. More compound interest accumulates over time, and the cycle of purchasing more shares will continue to help the fund, and one's initial investment in it, grow faster in value.
Consider a mutual fund opened with an initial investment of $5,000 and subsequent ongoing annual additions of $2,400. With an average of 12% annual return over 30 years, the future value of the fund is $798,500. The compound interest is the difference between the cash contributed to an investment and the actual future value of the investment. In this case, by contributing $77,000, or a cumulative contribution of just $200 per month over 30 years, compound interest comes to $721,500 of the future balance.
Automatic reinvestment plans are a great way to take advantage of compound interest. But taking the dividends and reinvesting in other parts of an investment portfolio can help increase diversification, since reinvesting the dividend back into the same mutual funds means that you're keeping a growing pile of eggs in the same basket. It may be prudent to use the dividends to create secondary safe harbor investments. Reinvesting dividends elsewhere can also be part of a rebalancing strategy.