Managing personal funds like a business: reinvestment and returns

It may not be the smartest thing to do but let’s face it, most of us treat investment as just a slightly fancier savings account. We put money into it and figure that, in due course, we’ll take it back out with a bit of additional interest. We’re in the habit of letting other people look after our money and simply accepting the way that eats into our profits – in fact, we often fail to see them as profits at all. Treating personal finance more like you’d treat a business could help you to make substantially more money over the long term. While there can be advantages to bringing in an investment manager if you’re dealing with very large amounts, for most people it makes more sense to develop the necessary skills and manage money directly.

A plan to suit your circumstances

The best way to manage your money will depend on what you want to get out of it. The key question is this: is it most important to you to have income in the short term or to have more money (even after accounting for inflation) in the long term? Everyone’s answer will be different and there is room to do a bit of both. You might want to resolve day to day struggles to make ends meet or you might want to put something by for retirement, say, or to buy a house. If long-term wealth is your priority, you shouldn’t just spend dividends when you receive them – you should reinvest.

Compound interest

Why does reinvestment benefit you? It’s because of compound interest. To put it simply, when you receive your next interest payment, it will be based not just on the amount you originally invested but on that amount plus the dividend you chose to reinvest. So let’s say you have £10,000 and you invest it at 5% interest – at the end of that year you will have £10,500. You could take the £500 out or you could reinvest it. If you do the latter, at the end of the next year you will make an additional £500 on your original investment plus £25 on the money you reinvested. Leave it all in place and at the end of the third year you’ll have a total of £11,551.25; do so again and at the end of the fourth year your invested money will add up to £12,108.81. Now imagine doing this with a larger amount of money invested at a high rate and you’ll see how fast small gains can add up to increase your overall income.

Why reinvest directly?

If you’re happy with the amount your money has increased by over the past year (bearing in mind that returns from most investments vary, so calculations are not as straightforward as in the example above), the simplest thing you can do is to reinvest it in the same place. Some funds and brokers offer the option of reinvesting funds automatically – check out this Alvexo broker review – so that you won’t need to do more than keeping an eye on things, which is ideal if you’re the sort of person who was happy with the savings bank approach. It gives you some control because you can always opt to change your mind and you’ll usually make more overall than you would if you just kept your money in a bank.

Moving your money

If you’re not happy with the rate of returns you’ve been receiving – if you look around at the markets and, after taking into account risk, it doesn’t seem very competitive – then it may be time to move your money. You can opt to do this with the whole sum, including your dividends, so that you continue to benefit from a compounding effect. What is then important is to make sure you find new investments that suit your risk profile. The easiest way to do that is to put your money into a pre-balanced investment fund with a good record of success. There are many such funds available and you can even find ones that suit your other concerns – for instance, investing in green energy or in companies run by members of disadvantaged minority groups.

Understanding tax

When you receive dividends on most investment types you will need to declare and pay tax on them even if you’re reinvesting them. The exceptions to this are ISAs and SIPP pension plans, though there’s a limit to how much you can invest in those tax-free each year. The first £2,000 of your dividend income each year is tax free, so you may wish to take this into account when deciding how much to reinvest.

Reinvesting your returns can give you a big advantage over people who simply spend them. In time, patience pays off – literally.