It is widely known that compounding is considered the eighth wonder of the world and this is quite accurate. It is a very useful one that can turn wealth into an exponential form over a certain period of time.
Here, the compounding factor may be related to the fixed deposits but it is equally powerful when it comes to mutual fund investments. In this segment, we will try to understand how the power of compounding works in mutual funds.
Checkout: The Story of Mutual Funds growth in India.
What is The Compounding?
Compounding is a concept whereby the profit retained in an investment is obtained from the previous profits earned from such investment. In simple terms, it is the profit earned on profits. When you engage in investing, you receive a certain amount of return from your investment.
If you reinvest those returns, then you get returns on the initial investment added to the returns you make from the said investment. This means that over several years, it will grow and become massive to that an individual’s wealth will have snowballed.
How Compounding Works?
To have a better picture of what compounding entails, it may be wise to have a look at an example. For instances, imagine that the company invests Rs. 1,00,000 in a fixed deposit with an interest rate of 10% per anum. Here's how your investment would grow over five years:
Year 1: Rs. 1,00,000 * 10% = Rs. 10,000 (interest)
Year 2: Rs. 1,10,000 * 10% = Rs. 11,000 (interest)
Year 3: Rs. 1,21,000 * 10% = Rs. 12,100 (interest)
Year 4: Rs. 1,33,100 * 10% = Rs. 13,310 (interest)
Year 5: Rs. 1,46,410 * 10% = Rs. 14,641 (interest)
At the end of each of the five years, the value of the investment, started with the principal amount Rs. 1,00,000, would be approximately Rs. 1,61,051. The simple interest would have summed up to Rs. 50000 for the period of a year, whilst making Rs. 61051 with compounding.
Compounding in Mutual Funds
The concept of the power of compounding in mutual funds is taken to the next level. When you invest in mutual funds, several people, including you, make separate investments, but the pooled money is used to buy various stocks, bonds or other securities.
Here's how compounding works in mutual funds :
Dividend Reinvestment:
Sometimes it is possible for a mutual fund to distribute dividends to investors. If you choose a dividend reinvestment plan, such dividends are used to acquire more units of the fund, thereby boosting the overall investment. These additional units can gradually add up and have a positive impact on your overall profit margin in the long run.
Systematic Investment Plans (SIPs):
SIP stands for Systematic Investment Plan which means you can invest a fixed sum at a fixed interval (such as monthly). This disciplined approach does not only allow you to invest steadily but also to take advantages of compounding. The more time an investment takes, the more the initial capital will grow in value or be simulated by assets.
Checkout: What is SIP in Hindi?
Example of Compounding in Mutual Funds
Let's consider an example of how compounding works in mutual funds investment through a SIP.
Investor A: Starts investing Rs. 2,000 per month at age 30.
Investor B: Starts investing Rs. 4,000 per month at age 45.
Both invest till they are 60 years old.
Assuming a 10% annual return, here’s how their investments would grow:
Age |
Investor A's Corpus
| Investor B's Corpus |
30 | Rs. 0 | Rs. 0 |
35 | Rs. 1.6 Lakhs | Rs. 0 |
40 | Rs. 4.1 Lakhs | Rs. 0 |
45 | Rs. 8.4 Lakhs | Rs. 0 |
50 | Rs. 15.5 Lakhs | Rs. 3.1 Lakhs |
55 | Rs. 26.8 Lakhs | Rs. 8.3 Lakhs |
60 | Rs. 45.58 Lakhs | Rs. 16.71 Lakhs |
Despite investing the same total amount (Rs. 7,20,000), Investor A’s corpus is almost 2.7 times that of Investor B’s due to the longer investment period. This demonstrates the significant impact of starting early and letting compounding work over a longer period.
Example Video:
How to Maximize the Power of Compounding?
Start Early:
Timing in investing is crucial because time helps the money to continue to gather that multiplied amount for the investment. Investment also underlines the fact that steady and consistent small amounts of money can translate to substantial amounts of money within a long period through compounding.
Stay Invested:
Always try not to take your money out from these investments earlier than required or expected. It makes use of power of compounding in mutual funds to ensure that the money accumulates in the right places without withdrawal disrupting the positive effects.
Increase Your Investments:
The following guidelines apply As your income increases then it is possible for you to consider increasing your investment amounts. This can go a long way in increasing your returns in the market in the long run.
Choose the Right Investment Plan:
Opt for dividend reinvestment plans or SIPs to take full advantage of compounding in mutual funds. These strategies reinvest your returns, helping you accumulate more units and grow your wealth.
Checkout: Top 10 Best Mutual Funds for SIP to Invest in 2024
Conclusion
Compound interest is an incredible tool when it comes to wealth creation and this shows how it plays out. Last but not least, by beginning this process, holding your investments, and deciding on appropriate strategies, this instrument can help you achieve your financial objectives.
In this context, mutual funds prove to be highly beneficial as they invest in diversified portfolios and have options for reinvestment, which, when combined with the power of compounding in the long run. Begin accumulating wealth today, and in time, you’ll be reaping the benefits of compounding.
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Eplore different types of investment services. Also, get more familiar with other such online products as the SIP calculators to make a right investment plan.
How the Power of Compounding Works in Mutual Funds