When your advisor tailors your financial plan, he relies heavily on the magic of compounding. It is only when your returns compound at the assumed rate that your investments can get you to the goal by due date.
But your financial plans can go awry if the interest payouts on your bonds or dividend payouts from your equities simply land in your savings account to be frittered away.
To avoid this, it is best to invest in the cumulative or growth options of debt instruments to make the most of compounding. Ditto for equity mutual funds. But if only the payout option is available with an otherwise attractive investment (say a share or a tax-free bond), ensure that you have a separate bank account to capture all income inflows and reinvest them.
Reinvesting dividends is quite important for your direct equity holdings, too. If you thought Indian stocks are all about capital gains, an evaluation of total returns (compounded returns assuming reinvestment of dividend) from equities over the last ten years tells a different story.
If you invested Rs 1 lakh in the Sensex basket exactly ten years ago (December 23, 2006), it would have appreciated to Rs 1.96 lakh by today with just capital gains. But had you diligently reinvested the dividends into the market every year, your investment would now be worth Rs 2.3 lakh. The gap between plain stock price returns and total returns is even wider for the broader market. For the Nifty 500 Index, you would be left with Rs 2.2 lakh without dividends but as much as Rs 2.5 lakh with dividends reinvested!
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