DEFINITION of Automatic Reinvestment Plan
An automatic reinvestment plan is a mutual fund plan that automatically reinvests capital gains back into the fund. In the case of a mutual fund, for example, capital gains produced by the fund would be used to automatically purchase more shares instead of being distributed to the investor as cash.
BREAKING DOWN Automatic Reinvestment Plan
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.
Compound Interest in an Automatic Reinvestment Plan
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.
How Automatic Reinvestment Plans Affect Reinvestment
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.