There are three sources of profit for equity investments. These are: Capital gain, dividends and reinvestment income. Reinvestment income is the result of reinvesting the dividends back to the same investment. Mathematically it is:
Total Profit = Capital Gain (or lost) + Dividends + Reinvestment Income.
For portfolio it may not be easy to track what is the exact amount of dividends because of the large number of securities in the portfolio. Fortunately common indices can tell us how much the total dividends and reinvestment income is available. Let's consider the MSCI World Index. This represents a globally diversified stock portfolio representating of all of the developed countries.
The MSCI World Gross index represents the performance of the portfolio assuming all divdends are reinvested (at no cost and no tax). On the other hand, the MSCI World Price index represents the capital gain of the portfolio, it does not take into account of dividends.
From 31 May 1989 to 29 May 2009, MSCI World Gross grew by 198% return or 5.61% per annum.
From 31 May 1989 to 29 May 2009, MSCI World Price grew by 94% return or 3.36% per annum.
(All returns in USD dollars.)
The difference in total return between the two index is 198%-94%=104%. This difference represents the sum of dividends and reinvestment income.
Thus, dividends and reinvesmtent income consists of 104%/198% = 52.59% of the total profit!
What does this really mean in dollars and cents? If you invest $100,000 in 31 May 1989, the capital gain is only $94,000 but the dividends and reinvestment income is $104,000!
Invest $100,000 in 31 May 1989, money grew to $298,000 consisting of:
* Original principal = $100,000
* Capitlal gain = $94,000
* Dividends + reinvestment income = $104,000
Many investors just concentrate in getting capital gain but they forgot that dividends and reinvestment can increase their profit by (198/94-1) =111% (in this example) !
In order to have reinvesmtent income, it is assume all dividends are reinvested. But this is not possible in real life because of:
1. Taxes. If the dividends are taxed, only the remaining are available for reinvestment.
2. Management fee of the fund manager
3. Brokerage fee of the brokerage house
4. Trustee fee of the fund's Trustee
5. Impact cost due to buying and purchasing in a illquid market
6. Bid-ask spread due to frequent trading
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