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Home : 2011 Back Issues : Article

Do You Understand the Math
of Dividend Reinvesting?

By Austin Pryor

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In The Best Savings Option for 2 - 3 Year Projects, we profiled short-term bond funds for savers with a time horizon of two years or more. Short-term bonds represent a step up the risk/reward ladder from money market accounts and money market funds. During periods of rising interest rates, short-term bond funds can show small losses. But investors often think the results in their short-term funds are worse than is the case. That's because they focus exclusively on the price per share, failing to take monthly dividends into account.

Consider the table below that shows price and dividend information for the Vanguard Short-Term Investment-Grade bond fund (one of the bond funds regularly recommended by SMI for your accumulation fund investments) during the first nine months of this year. If $3,000 was invested at the end of 2010, an investor would have initially acquired 278.5515 shares. With the fund closing in September at $10.66 per share, it appears at first glance that the fund has lost money. An 11-cent decline in share value equates to a loss of roughly 1%.

Table: Vanguard S-T Investment Grade Fund

This overlooks, however, the fact that the fund pays monthly dividends to its shareholders. Since these dividends are paid from the assets in the fund, typically on the last business day of the month, they are deducted from its net asset value at that time. This reduces the share price as shown in the newspaper that day. The Vanguard fund paid 2.792¢ per share at the end of January, 2.443¢ at the end of February, and so on.

Most Level 2 savers sign up to have their dividends reinvested in more shares. In our example, the January 31 dividend totaled $7.777 (2.792¢ per share times 278.5515 shares). Since the fund closed at $10.80 on that date, the dividend was almost able to purchase a full additional share (0.7201 to be exact). As a result of this reinvesting process each month, our investor's account grew to 285.4988 shares by the end of September. (This includes a 3.90¢ per share capital gain distribution on March 21. For the purposes of this discussion, this is handled as if an extra dividend was received on that date.) When this share total is multiplied by the September 30 closing price of $10.66 per share, the investment is shown to have grown to $3,043.42. This equates to a 1.45% nine-month total gain rather than the 1% loss that it first seemed.

If you're building an accumulation fund (see Ch. 7 of the Sound Mind Investing Handbook), perhaps it's time you take a look at the kinds of bond funds we've been discussing. They won't outperform money market accounts every month, but you'll likely be pleased when you make year-to-year comparisons.

Austin Pryor has three decades of experience advising investors, and is the founder of the Sound Mind Investing newsletter and website. Austin lives in Louisville, Kentucky, with Susie, his wife of 46 years. Two of his sons, Andrew and Matthew, work with him at Sound Mind Investing. A third son, Tre, is a Realtor® in the area.