Dividend reinvestment (tutorial #9)

Many stocks pay dividends to their shareholders regularly, which is typically quarterly. For instance, in 2011, Wal-Mart Stores, Inc. paid a dividend of $0.365 per share on March 9, May 11, August 10, and Dec 7.

What do investors do with these dividend payments? Well, one option is to spend them. If you owned 1,000 shares of Wal-Mart in 2011, you would receive a dividend of $365 in each quarter, or almost $1,500 in total over the year. You could spend this money on whatever you like.

If you don't want to spend your dividends, you can reinvest them in Wal-Mart (or in any other asset). For instance, after receiving your first dividend payment of $365 on March 9, you could use these funds to purchase additional shares of Wal-Mart. Given that Wal-Mart closed trading at $52.67 on that day, you could purchase roughly 7 more shares of Wal-Mart.

Remember the multi-period return formula we introduced in the previous tutorial:

HPR_T = Π ( 1 + R_t ) - 1   where   t ∈ [1, T]

It is important for you to know that this formula assumes dividends are reinvested in the asset. That's why the formula uses total returns R_t. Your holding period return would be lower if you spent the dividend payments rather than reinvesting them.

Next tutorial: Arithmetic vs geometric average return
Previous tutorial: Single- vs multi-period returns

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