Two Tales of One Investment Income
By Desty on Aug 13, 2007 in Investing
There are two choices for pure investors when it comes to dividend returns from a stock:
- Use a dividend reinvestment plan to dollar cost average the dividends back into the stock.
- Separate the dividend income into a cash pool to reinvest into a different asset. Does not need to be stocks, can be business investment, real estate, etc. This tactic increases the velocity of the investment into and funnels it into targeted investments where the entry to the asset can be controlled.
A difficult choice. A tried and true tactic for investing over the long term (dollar cost averaging) going against an investor’s need for ROI (return of investment) and the continuing need to have his money working and bringing a return (velocity of money).
Dollar Cost Averaging
Dollar Cost Averaging is an automated approach to investing. You invest your weekly / monthly amount of cash into your chosen stock on the exact same day, regardless of price. High, low, price doesn’t matter, the theory is that on average you will buy on low price days along with high price days and that will even itself out; as such, you will buy lesser amounts when the price is high and buy more of a stock when the price is lower. Throw along with that dividends being reinvested, you have your money working for you; since you’re using dollar cost averaging, you don’t care how much the price will be when those dividends are reinvested, it will even out. The effect of the dividend reinvestment is akin to compound interest; the effect is the same, your money makes money that in-turn makes more money and continues the cycle. It’s a very powerful force and the longer it continues, the more powerful it becomes. It’s the reason why a young person can make small investments, they compound over time, and create a large amount of net worth.
The Velocity of Money
The Velocity of Money is a tactic where the investor, after the asset grows either through capital appreciation or dividends, takes out the amount equal to the initial investment in order to invest that capital into another venture. Now the investor has his initial investment back and in another investment while the original asset still exists free and clear; the original asset is now “free” and can then use compound interest and dividend reinvestment to grow. The main goal of this strategy is getting that ROI and still having an asset remain. An example of this can be found in Real Estate. A rental property is bought for $100,000 ($20,000 down) and after 10 years has its value doubled to $200,000. The investor refinances, pulls out his original $100,000 to invest somewhere else, and still owns the house. Not only was the investment free from a dollar amount point of view, but the investor made a VERY nice paper profit of $100,000. An example in the stock market is to not reinvest dividends, but to redirect them into another investment until the amount of dividends harvested equal the original investment, afterwards dividend reinvestment is the smart choice to allow compound grow the take hold.
What Do You Want Out of Your Investment?
Dollar cost averaging and the velocity of money are, in the end, tactics. Tactics are tools used within different strategies. Dollar cost averaging is used in a long term strategy. Velocity of Money is more of a short term strategy with a predefined exit in mind. The pure investor’s primary concern is how long will it take to get his investment back; once the investment capital is returned, then it’s time to look for profit.
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Great post! Have you read Robert Kiyosaki’s book “Who Took My Money?” It’s an awesome book that goes into great detail about the differences of these two tactics.
I’ve got it as a book on CD. It’s in my rotation between his original 3 books, the Richest Man in Bablyon, and How to Get out of Debt By Not Cutting Up Your Credit Cards.
The 1st time I heard the CD, it went totally against what I had been taught growing up about saving and investing (ie dollar cost averaging). It’s still difficult to pull money off the table when you’re making so much in interest / dividends.