Power of Compounding in Mutual Funds
By Akhil Chugh
Date March 6, 2022
“Compound Interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t pays it” – Albert Einstein
In the world of finance, an often acknowledged and valued concept is compounding. Creating wealth is an art, you cannot accumulate wealth by earning windfall. It can only be attained by the right & disciplined investing of one’s resources. Even a small amount invested in the right investment product can get accumulated in the ocean of wealth. It feels great when our money works as hard to grow as we did to earn it! Well, this can be accomplished by the magical concept of compounding.
The power of compounding can be understood better with the “snowball effect,” wherein you can see how a small ball of snow builds upon itself to form a much bigger snowball as it rolls down a slope because it picks up even more snow every time it goes around. Compounding produces a snowball effect with money because the earnings each year contribute a little more to earnings the following year. As time passes, the earnings contribute more and more to the total value of an investment.
What is Power of Compounding?
Compound interest or compounding means you not only receive the interest on the basic principle amount that you have invested, but also on the interest that keeps getting added to it.
It means reinvesting the interest earnings you get from your initial investments instead of spending it elsewhere.
For example, if you invest Rs 10000 with 8% interest every year, then your principal amount is Rs 10000 and the earnings, at the end of the year, are Rs 800 (8% of Rs 100). However, instead of spending it, if you choose to reinvest it, then your principal amount for the next year becomes Rs 10800 (Rs 10000+ Rs 800) and the earnings you get are Rs 864 (8% of Rs 10800), which are Rs 64 more compared to the first year. Compounding is a mathematical phenomenon where when you invest your money, that money earns returns and that return also earns a return. This accelerates the growth of your investment.
Even though this looks like a small amount, it can make a huge difference to your accumulated wealth, if you let the magic of compounding work over the long term.
How does the Power of Compounding Work in Mutual Funds?
When it comes to unleashing the power of compounding, time is your best friend. This is why long-term investment options allow you to utilize the potential of compounding more fully. Now, when it comes to mutual funds, there is generally no lock-in period. So, you can either choose to exit after a short period, or you can choose to remain invested for the long term. However, to tap the full potential of compounding, a long-term investment horizon is recommended to achieve your desired corpus.
The money invested in mutual funds via SIP or lumpsum is your principal and the excess that you may earn on it gets compounded over the investment period. In simple terms, the excess earned on your principal investment gets added back to your principal. This results in an increasing rate of growth for your mutual fund investments resulting in exponential returns over a period of time.
The power of compounding is directly proportional to your investment tenure. The longer you stay invested, the better returns you reap. Therefore, Net Brokers suggest its investors to start early and stay invested for a long period of time to reap the benefits of compounding.
How to Leverage the Power of Compounding?
To tap the full potential of compounding, a proper strategy needs to be followed, and here is what you can do to make the most of this tool.
1. Start early:
Investors who start off early onto their investment journey go on to create a much larger corpus than those who begin late. For compounding to work, what counts is not only the rate of return but how long we keep investing. So, develop that investing habit in the early stage of life.
Wealth cannot be accumulated overnight, like a tree it needs to be nurtured. Compounding teaches us that it does not take too much money to save a decent amount. What is required is the discipline of regular saving and time on your side. The longer the time better will be the return.
Let us look at the below illustration to understand how starting early can work to your advantage in creating a larger corpus (> 2x) with the same amount of equity mutual funds investment (Rs 1.8 cr) beating inflation in the long run.
Rohit and Mohit are friends who have just started their career at 25 and plan to retire at 55. Rohit starts investing ₹50,000 every month via SIPs in equity mutual funds from age 25 and continues to do so until he is 55 years old. Mohit, on the other hand, starts monthly SIPs of ₹75,000 in equity mutual funds from the age of 35 and continues to do so until he retires at the age of 55. If both earn, say, 12% CAGR on their mutual fund investments which is Rs 1.8 cr, Mohit would accumulate Rs 7.5 cr at the retirement age while Rohit would accumulate Rs 17.6 cr which is more than 2x Mohit’s wealth. This is the magic of compounding.
Thus, the longer you stay invested the more money you will make. The best way to take benefit of compounding is to start saving and investing wisely as early as possible in equity mutual funds aligned to your financial goals. The earlier you start investing, the greater will be the power of compounding.
2. Be a disciplined investor:
To reap the full benefits of compounding, investors must inculcate an investing discipline to ensure that investments meet the desired goal. Consistency and investing with defined objectives are the key to successful returns. Investments made in a uniform manner can help wealth grow at an exponential rate.
3. Learn Patience:
Patience is one of the most important ingredients of wealth creation. Don’t be easily enticed into making pre-mature withdrawals to jeopardize your fund’s growth potential. Instead of quick returns, you must focus on giving ample time to your investment so that they can grow into substantial wealth, with the help of the power of compounding.
4. Control your expenses:
Managing expenses is one of the biggest steps investors need to take in order to accrue returns consistently. Investors must have sufficient liquidity in order to leverage investment opportunities as and when they arrive and ensure that there are enough funds available for investing regularly.
Key takeaways from Net Brokers:
- Compounding simply means the interest earned on interest which leads to substantial growth in investments and savings in the long run.
- The best way to take advantage of the power of compounding is to start saving and investing as early as possible.
- Raise your investments via SIP Top-ups with rising income to harness the power of compounding.
- Identify a mutual fund that is in line with your financial goals and start investing via SIPs. Use SIP Calculator Tool on Net Brokers App to know exactly how much you need to start investing today to achieve your future goals.
Net Brokers strongly suggest investors invest regularly via SIPs at the start of your investment journey in the mutual fund schemes aligned to your financial goals.
Be disciplined & have the patience to reap healthy returns as the magic of compounding unfolds over time!
For more information, get in touch with us today! Download our mutual fund app & start investing for your long-term financial goals.
Happy Investing!