A mutual fund is an investment vehicle that pools money from many investors to buy securities such as bonds and stocks. When dividends are distributed, the mutual fund owner has several options. The dividends can be taken as a check that is mailed to the investor, they can be moved into a savings-type account, such as a money market fund, or they can be reinvested in the mutual fund.
Mutual funds make it easy to compound the return on your investment. When dividends are distributed, if you reinvest them in the fund, you buy additional shares -- even fractions of shares -- of the portfolio. The next time dividends are distributed, they will be based upon your original investment plus the additional shares purchased with the previous dividend reinvestment. Each dividend reinvestment will result in more shares in your account, an easy and automatic way to grow your investment.
Dollar Cost Averaging
Buying the same dollar amount of an investment, over a regular time interval, is called dollar cost averaging. With this technique, fewer shares are purchased when the price is high and more shares are purchased when the price is low. Typically this results in a lower cost per share. Reinvesting dividends is an excellent way to take advantage of dollar cost averaging without the investment of more money.
Some mutual funds can only be bought by paying a sales commission -- whether to the fund or a broker. By using dividend reinvestment you are able to purchase additional shares in the fund without paying a commission or any other charge. Without this expense, you will improve the investment’s total return.
Money Keeps Working
Dividends that are paid to you in cash or transferred into a savings account become money that is no longer working for you. If you receive the money in cash, you may spend it. By reinvesting the dividends you keep the money working for you and the investment growing.
Diane Stevens' professional experience started in 1970 with a computer programming position. Beginning in 1985, running her own business gave her extensive experience in personal and business finance. Her writing appears on Orbitz's Travel Blog and other websites. Stevens holds a Bachelor of Science in physics from the State University of New York at Albany.