Although the term seems like something out an advanced economics class with little real life relevance, there are circumstances where an investor should be aware of reinvestment rate assumptions. As you plan the growth of your investments, you should understand if the growth calculations depend on assumed reinvestment rates or actual reinvestment of earning.
A reinvestment rate assumption can be defined as the specific interest rate at which funds could be reinvested in order to take advantage of predicated fluctuations in the marketplace.
Assessing the Time Value of Money
In the world of finance, the time value of money concept helps define and compare the value of current and future cash flows. When financial analysts calculate the widely used internal rate of return metric, called IRR, the calculation is based on a selected reinvestment rate assumption. The reinvestment rate assumption definition is derived from this process.
This means that in the calculation, any cash flow – such as earnings, interest, rents or dividends – are reinvested at the assumed rate. The rate assumption for reinvestment can have a significant effect on the projected results for an investment or project.
Exploring Reinvestment of Earnings
When you look at your projected investment returns, a major consideration is what happens to earnings such as dividends and interest payments. With a mutual fund, you can have dividends automatically reinvested into more shares, compounding the rate paid by the fund.
With stock dividends or bond interest, if those cash payments just build up in your brokerage account, you do not have much in the way of a reinvestment rate. If you do not reinvest your earnings at a rate similar to your growth assumptions, the result is a lower probability of meeting your investment growth goals.
Understanding Bond Yield to Maturity
With bond investments, reinvestment rate assumption is cooked into the rates quoted by your broker. The yield-to-maturity rate for a bond assumes that the interest coupon payments will be reinvested at the same rate as the calculated yield-to-maturity quoted for the bond.
If the interest payments are not reinvested or get invested at a lower rate, the total return from the bond will be slightly less than the quoted yield-to-maturity rate if the bond is held until it matures and the principal pays off.
Other Practical Considerations
If your investment goals include the long-term growth of your portfolio value, develop a plan concerning earned dividends and interest. Put together your own reinvestment rate by using the portfolio earnings to buy more investments that will pay additional income.
Earned cash can also be used to implement an asset allocation strategy, investing the money when you rebalance your portfolio assets, avoiding some of the selling that would be necessary if you did not have the earned and accumulated cash to invest.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.